ba (hons.) dissertation
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This was my dissertation on the efficiency of the capital markets in developing countries compared to those in developed countries. The results came conclusive that there is insider trading present regardless of the territory of the capital market.TRANSCRIPT
University of East Anglia | City College Norwich
BA (Hons.) Business Management
Word Limit 10,000
Dissertation
The purpose of this study is to test and compare the efficiency of stock markets in emerging economies compared with those in developed markets. If a stock market is ‘efficient’, it is said that the price of a stock reflects all information concerning a company’s fundamentals (such as earnings reports, news of mergers and acquisitions or pre dividend announcements to name a few) weather such information is available to the general public or has yet to be released to the general public, or more specifically, the shareholders.
A Comparison of Stock Market Efficiency between the US and Emerging Markets
Contents Page
Learning Outcomes 3
Summary 3
Literature Review 4
What are the Stock Markets 8
Three categories of market efficiency 9
Key Features of an Efficient Market 11
The Efficient Market Hypothesis 11
How do Efficient Markets Benefit Investors and Firms? 12
Definitions of Insider Trading 13
Who are Insider Traders 15
Typical Insider Trading Scenarios 16
Research Aim, 18
Methodology 19
Implications 19
Assumptions 21
Data Analysis: Observations 21
Conclusion 24
References 28
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A Comparison of Stock Market Efficiency between the US and Emerging Markets
Learning Outcomes
Allows transferal of knowledge form a Literature Review to give a critical analysis to
the hypothesis/question of the study
Demonstrates independent reflection and initiative by applying the appropriate and
systematic research methodology to the problem of issue
Applies relevant concepts, theories, and evaluate techniques when analysing results in a
chosen area
Demonstrates the ability to draw defined conclusions from the research undertaken.
Summary
The purpose of this study is to test and compare the efficiency of stock markets in
emerging economies compared with those in developed markets. If a stock market is
‘efficient’, it is said that the price of a stock reflects all information concerning a
company’s fundamentals (such as earnings reports, news of mergers and acquisitions or
pre dividend announcements to name a few) weather such information is available to the
general public or has yet to be released to the general public, or more specifically, the
shareholders.
The focus of this study will be to determine that there may be a possibility, or not, of the
presence of insider trading taking place in emerging economies by testing to see if
investors within those stock markets achieve significantly abnormal returns compared with
the stock market average. This report will further explore the laws and regulations
currently in force in two economies: the United Stated and Mexico, of which have very
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contrasting economics and wealth in terms of poverty and productivity, and to see how
well they actually work in deterring insider trading today.
Insider trading takes place where market participants are privy to and trade on information
which will not be released to the general public until a later date. This information will
have the power to move a stock price, such as a lawsuit or a profit announcement, and the
aim will be to generate large profits for the market participant if they trade on this
information. The aim of this study is to come to a conclusion as to how efficient the
markets in developed and less economically developed countries (L.E.D.C) countries are.
On a total of 103 countries which have stock markets resided in them, 87 of those nations
regulate insider trading activities but in varying degrees in terms of the severity of the
punishments and penalties that would follow when prosecution is brought before the law
(Bhattacharya & Daouk, 2000). The research of Bhattacharya & Daouk, (2000) concluded
that the regulation of insider trading appears to prevent those with information advantage
from trading at the expense of those who are not informed about such information.
The Standard Event Methodology, which is a widely used tool to test for various
characteristics in stock markets, will be applied here to, firstly, see if investors do react to
news broadcasts concerning the companies of which are being traded on the various stock
exchanged across the world: this is classed as the ‘null hypothesis’ or is otherwise known
as the ‘hypothesis of the status quo’, or if investors do not react to such information: this
will be classed as the alternative hypothesis. Secondly, the Event Study, as this is also
known as, will test to see if investors have achieved significantly abnormal returns by
measuring the difference between the expected returns (which is calculated using the
standard linear regression analysis) and the abnormal daily returns from the individual
shares, prior to such information being made public.
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The right trading environment to trade on insider information is only when the markets
possess semi-form efficiency characteristics, and that financial managers have inside
information or knowledge, can the right environment be created for managers to gain
advantage and to exploit such insider information in order to realise excessive or abnormal
returns compared to the market average (ACCA, 2009).
Insider trading is not easy to estimate because people are reluctant to report it because of
the severe penalties in force if this was detected (Bris, 2005, p.269), and very few tests
outside of the US have been conducted at the time or writing, however, one research paper
was found on the Athens (www.athens.ac.uk) website which focused on the presence of
insider trading which was detected by applying the same event study, as this report will use
to test for insider trading in Mexico and the US, on the Istanbul Stock Exchange. The paper
was written by Dogu, Karacaer and Baha Karan, (2010) titled ‘Empirical Testing of Insider
Trading in the Istanbul Stock Exchange’. Research carried out on the ISE concluded there
was evidence of insider trading present by showing that abnormal returns were achieved
ten days before the news release on a company which was listed on the exchange. This was
where buyers started purchasing stocks when the information in question was leaked to the
public. After the news was released, excess returns failed to break through the positive
boundary (Karacaer and Baha Karan, (2010).
Literature Review
Arguments for and against insider trading
The US has the strictest laws relating to insider trading, along with the UK and Canada,
where insider trading is strictly forbidden under Section 10(b) of the Securities Exchange
Act (1934), (SEC, 2012, Brody & Perri, 2011). The act goes even further by not only
addressing the corporate insiders on this act, but also to those who are known as
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constructive insiders, and outsiders who are made insiders by a tip-off or through personal
or professional relationships. Constructive insiders are those who are informed by insiders
whom have a duty to keep such information personal until the time arises when this is
officially released into the public domain (Bris, 2005)
However, despite the enormous amount of legislation around insider trading, arguments
are still in fever pitch amongst scholars and practitioners whereby they argue on one side
of the coin that insider trading should be revoked, and on the other side (mainly the
regulators) state that insider trading is morally wrong, it deters investors and destabilizes
investments. It is not surprising then that this is the view of the Securities Exchanges
Commission which is established to protect investors and maintain and fair and level
playing field in US-Domiciled money and capital markets (SEC, 2012).
A question of theft
Velasquez (2002) talks about the two main arguments against insider trading, stating that
insider trading is extremely harmful to the markets. Insider trading trades on information
which is stolen and that such information belongs to the corporation. Any asset that is used
by an insider for a gain, that gain morally belongs to the corporation it was taken from.
Georges, (1976) further elaborates on this by saying that preferential information belongs
to the company, so any exploitation of such privy information carried out by anyone other
than the company, this could be argued as theft.
A question of Fairness
The second argument questions the fairness of advantage of an insider having information
or knowledge over another investor. It is often the case that two parties do not have equal
knowledge when coming to a transaction because of the differing levels of due diligence
and analysis, however with insider trading, one member of that party has no way of
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obtaining insider information regardless of how much research or due diligences has been
carried out on a particular stock prior to trading, unless that individual was in an extremely
privileged position or the moral or legal right to that information is questionable.
A further argument which Velasques, (2002) points out is of the effect insider trading has
on the market itself: it reduces the size of the market because investors are reluctant to
trade in a market which has high levels of insider trading. When fewer people trade in a
market, this leads to the markets being less efficient, more volatile and less liquid.
Arguments for insider trading are put forward by Block and McGee (1992) who state that
no individual has a moral obligation to disclose that a price will change once non-
disclosed information about a stock becomes disclosed. They also view that insider trading
is not fraudulent because there is no loss. This argument is supported by the mechanism of
buyers and sellers that if a buyer is buying stocks based on inside information a seller can
benefit from capital gains because the price is now pushed up from the buyers. However,
King & Roell, (1988) say that insider trading does create losses to the market makers who
will increase the spread, or the costs associated with trading the markets incurred by the
market participants, to maintain long-term profitability. This operates as a tax to market
participants and increases a disincentive to traders not to trade. This is also the main
argument of the regulators.
Further arguments against the practice of insider trading suggest that this discourages
investment as well as damaged corporate value due to non-insiders facing an adverse
selection problem, (Manove, 1989: Ausubel, 1990: Fischer, 1992). Furthermore, Brudney,
(1979): Easterbrook, (1985): Glosten, (1989):& Maug, (1995,2002), state that this
diminishes investor confidence and damages the integrity of the capital markets.
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A point put forward by Bainbridge, (1988) states that the ban of insider trading reduces the
market’s efficiency as well as managers’ compensation. Manne (1966) supports this by
arguing that the prohibition of insider trading causes the stock markets to become less
efficient (based on the three varying degrees of efficiency as will be explained later on)
and the stock price will deviate from its fundamental value.
In a 2002 interview on CNN, Nobel Memorial Prize in Economics laureate Friedman
Miller supports insider trading by stating that ‘you want more insider trading, not less and
wanting to give the people who are aware about any company deficiencies (insiders) an
incentive to make the public aware of this (by pricing this into the stock price), CNN,
(2002)
Arguments put forward by Carlton and Fischel, (1983): Dye, (1984) in support of insider
trading by saying that any restrictions should be revoked because this practice thus allows
private information to very quickly become incorporated into the stock pricing mechanism
which will ultimately lead to that stock becoming more informationally efficient.
There is also no violation of rights for non-insiders because they, again, achieve capital
gain from the rising price of the stock, making a profit, and so the act cannot be unjust.
They conclude that if the transaction is non-fraudulent and that if no-one’s rights have been
violated then there is nothing unethical about this practice. Insider trading has no victims
because any transactions carried out by the insider moves the stock price in the direction of
the preferential information and the counterpart will benefit from selling the stock at the
higher price and thus achieving a capital gain from the price increase. They also give a
truer reflection of the market price of a stock based on all information regardless of its
public availability – strong form efficiency- and also the opportunity to generate more
capital gains and income taxation for the economy, (Herzal & Katz, 1987)
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Finnerty (1976) says that the regulation of insider trading exploits market efficiency as its
strongest form as the stock price reflects all information, preferential included and hence
the insider pushes the stock price faster towards a better reflection of the fundamentals of
the company.
Hague et al, (2004) stated that a key characteristic of Middle Eastern stock markets are that
they hold low liquidity, meaning less traders in the market. Bhattacharya et al (2000) also
says that emerging markets are the least efficient markets as they are prone to pre-
announcement leakages to market participants. When the news is released into the public
domain, this is already ‘priced in’ to the stock. However, this contradicts what others have
said about a market being weak-form efficient: in the ACCA (2009) it says that a weak
market’s prices only reflect past price movements where a strongly efficient market
reflects all past price movements and includes all publically available information as well
as insider information as well.
What are the Stock Markets?
Firstly, the stock markets, or more specifically a ‘market’ comprises of a mixture of buyers
and sellers of stocks, bonds, commodities and foreign exchange instruments whose price at
which those instruments are purchased and sold at being determined by supply and demand
forces, (Kahn, 2006). However, the prices are only determined by supply and demand
when there is a free market: that is, a market which is not influenced by government. Kahn,
(2006) goes further to explain the prime movers of such markets as:
The market is comprised of buyers and sellers
Price is determined by supply and demand
Supply and demand are determined by the aggressiveness of the bulls and bears
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Bullish and bearish actions arise from perceptions of value
The market is a representation of all participants’ actions and perceptions of economic
forces of the companies within those stock markets and the economy as a whole. A
stock market chart is the graphical representation of such perceptions and actions
(Perception = reality).
The three categories of market efficiency
Market efficiency is categorised in terms of the characteristics they possess, these are:
weak-form efficiency – these apply to stock markets where the current price is reflected
by past price trends: Fama (1970) in fact states that all financial assets traded on a stock
exchange cannot be traded using information contained in the sequence of past prices.
Semi-strong form efficiency applies to markets where the current price is reflected by
past price trends and all publically available information. The strong form efficiency
theory applies to markets where the current price reflects past price movements, all
publically available information and private information as well. In other words, the
market is said to be efficient and ‘perfect’ when the price represents a fair and accurate
economic picture of a company by the company’s stock market valuation. It is also
important to note that, although efficient market pricing represents all available
information, it is about timing of the changes in price as new information becomes
available. This will create an imbalance of supply and demand of such shares as new
information becomes known to the public (ACCA, 2010)
Efficient market prices will change quickly to reflect new information where inefficient
markets will take a longer period of time to adjust to the new information as this gradually
becomes known and acted upon by different market participants through the course of time
or that the information has been leaked and acted upon prior to its official release (ACCA,
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2010) This was evident in the research carried out on the Mexican and the US markets as
well.
To further illustrate this point, Yu, & Leistikow, (2011 pp.151-172) states that in a
‘perfectly efficient market’, traders and investors should not be able to make abnormal
positive returns using publically available information. Dimson and Mussavain (1998) say
that trading on available information through legit channels fails to provide an abnormal
profit.
Kahn (2006) sums up the existence of trends in an imperfect market resulting in uneven
information dissemination across all the market participants. The price movements in these
markets are the reason as to why traders trade the market: to take advantage of the price
movements and generate a profit.
Weak-form efficient markets – based on price movements solely – are traded by technical
analysis. This analysis is the opposite of a fundamental trader where information sources
from earnings reports, news broadcasts and annual reports are used to determine how a
business will fare in the future and therefore, weather to purchase a stock. Technical
analysis, Kahn (2006) puts forward the question of how traders can possibly rely on such
data which is subject to constant revisions. The role of technical analysis is to assess
current prices and where they are likely to go, based on past price movements governed by
the bulls and bears of the market (Kahn, 2006)
Levine (1997) states that a well-developed stock market promotes better economic growth,
better ability to attract higher international investment (capital inflows) and mobilize
domestic savings.
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Key theoretical features of an efficient market
There are key features of an efficient marketplace and according to ACCA, (2010) these
key features, or characteristics of such efficiency are; the price of a security reflects all
information available in the public domain and that the share price will change quickly to
reflect newly released information, secondly, no individual dominates the market, investors
are rational, there are low or no costs to acquire information, and that transaction costs (or
spreads) are not so high as to discourage buyers and sellers from participating in the
markets. Dimson and Mussavain, (1998) state that if markets are sufficiency competitive
then investors cannot expect to achieve superior returns from their portfolios whilst
implementing their investment strategies.
Dimson and Mussavain, (2000) say that the term ‘efficiency’ describes a market which
has all relevant information reflected in the price of financial assets. This is an important
point to highlight because many economists use the term ‘efficiency’ when they refer to
‘operational efficiency’ which describes the way in which resources are used to facilitate
and operate the capital and money markets. For this research we will use the term
‘efficiency’ to illustrate how company information will be reflected into the price of a
stock.
The efficient market hypothesis (EMH)
The EMH applies where all prices react quickly to all available information and so
therefore investors cannot obtain higher than average returns from a well-diversified
portfolio. Dimson & Mussavian, (2000) further support this by stating that if capital
markets are sufficiently competitive, then investors cannot achieve superior profits from
their trading strategies. Fama (1976 p.113) talks about markets being efficient at
processing new information and that all prices will reflect all available information.
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Kavussanos et al (2008) talks about perfect markets as those who price all new information
into their pricing mechanism simultaneously, however, lead-lag relationships, on the other
hand, exist when one market reacts faster to information than the other.
How does efficient market benefit investors and firms?
Because the stock market is efficient and, in theory, therefore investors will react in a
‘rational’ way, a firm investing in projects generating returns in excess of the minimum
required Net Present Value (NPV), the stock prices will adjust to this new information.
Investors will purchase its stock in anticipation of a rise in future profits and dividends (if
the firms pay dividends). The effect of this is the rise in the share price as a result of the
new imbalance of supply and demand; in this case demand exceeds supply which causes a
rise in share value, and reducing the firm’s chances of a hostile takeover (ACCA, 2010)
The current stock market price of the share is taken into consideration when calculating the
cost of equity as a percentage using the dividend growth model, which is in turn used as a
discount factor to apply to investment appraisals carried out by the firm when making
future investment decisions. This discount factor is used to discount against expected
future earnings and cash movements (ACCA, 2010)
The same applies if the opposite happens in that if the firm generates negative NPV’s from
their cash movements, its shareholders will be aware of this happening and so they will sell
the stock, therefore drive the stock price downwards and giving a fair stock market
valuation of that company because of the new imbalance of supply exceeding demand.
Market prices will also fall if interest rates increase because investors will want a higher
return on their investment (ACCA, 2010)
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Definitions of Insider Trading
Insider trading is the trading of stocks and shares based on information of which is not yet
available to the general public, this is information which might influence the investors
decision to buy, hold or sell a stock based on weather this is positive, neutral or negative.
‘Insiders’ can come under a range of people in different occupations as market participants
or spectators. These can be company directors, investment managers, big shareholders or
company employees, brokers or analysts. So it is therefore obvious that these groups have
a monopoly over other investors which do not have such insider information, and if all
market participants could legally trade on such knowledge these would have a powerful
advantage of gaining excessive returns over the typical investor.
Misra, (2011, p 163) state that an individual would chose to indulge in inside trading to
generate profits or to avoid losses outside the normal rational decisions for buying and
selling securities based on publically available information. However this is only possible
with the possession of non-public, price sensitive information.
O’Hara (2001, p1047) stated that an insiders can be classed as any group or person that
gains such privileged information and comes under the categories of employees, managers
or directors of a company. Individuals can become insiders in a more intimate capacity
such as through family or friends, or close but external business associates. Also those who
have a contractual linkage such as suppliers (such as printers of company Annual and
Financial Statements) could be deemed to be insiders if they copy or withhold information
they were privileged to see or that they would see such information anyway in order to
conduct their job.
Haggerty and Fishman, (1995) state that insiders have also manipulated the markets by
announcing a piece of news, or several news items, to the public which has the potential to
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move a stock price and therefore create opportunities for profit potential for upcoming
transactions.
The Financial Services Authority’s objective is to ensure that the stock markets are clean,
orderly and efficient. Although they do not believe that the UK markets have a high
activity of insider trading, they are also aware that there are a small handful of people
whom are prepared to act in an unlawful way when participating in the financial markets.
Insider trading raises costs to everybody else, increases volatility, and undermines
confidence. According to the FSA, (2011) financial institutions are required to submit their
transactions by the close of business on the next day after the transaction took place. This
enables the FSA to monitor and detect any possible market abuse activities from these
firms. For instance, firms are required to submit all transactions taking place on the
Monday by the close of business on the Tuesday. Failure to do this results in companies
paying very hefty fines! For example, the London-based spread-betting firm City Index
(www.cityindex.com) failed to submit approximately 55,000 transactions and reported
around 1,970,000 transactions incorrectly by errors in the relevant data fields. They were
fined £490,000, taking the 30% early settlement discount (FSA, 2011)
If the market is a public good, then the exploitation of insider information and having that
monopoly over other investors is damaging to the market itself. The enforcement of a ban
of insider trading increases confidence and trust in these markets which will encourage
investors to trade and maintain liquidity in such markets (Minenna, date not known)
In more recent times the FSA has become increasingly concerned with institutions’
abilities to exploit information of which they are legitimately entitled to for legitimate uses.
This has been evidenced from the work they have carried out over the years in monitoring
the markets with the aim of assessing market cleanliness. They have seen that stock prices
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have risen before the announcement of an M&A which suggest that informed trading has
taken place.
A key area of focus is on the investment banks: more specifically the relationship between
these investment banks and their clients. This is the case because there is the risk that the
client can become an insider when he/she is made aware of an up and coming deal on a
particular company or stock.
Who are inside traders?
The Code of Market Conduct states than an insider is classed as a ‘regular user’ and is one
who is a ‘reasonable’ person who deals regularly with and has an intimate understanding of
how the financial markets operate. There is also a test for a ‘reasonable person’ which
employs similar techniques used in the English courts (Hu and Noe, 1997)
An individual or group can become an insider as a result of being in one or more
situations:
An individual as a result of their membership of the administrative, management or an
issuer of qualifying investments
As a result of holding capital of an issuer of prescribed investments
As a result of criminal activities
When an individual or group obtains information by other means such as a tip-off
from a friend or another individual who knows or could be reasonably expected to
know certain information which is not publically known, and that could potentially
change the share price.
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Someone who has access to such information as a result of their employment, duties or
profession
To put this into a real-life situation there have been many cases where individuals and
companies have been prosecuted and sentenced for insider dealings. In 2010 five
individuals, including two former directors and a former senior trader employed by a
company called Blue Index Ltd, which was a specialist Contract for Differences (CFD)
firm, were charged with 17 counts of insider dealing. One was charged with three offences
of trading ahead of three separate takeover announcements, a former employee was
charged with one offence of trading ahead of one takeover announcement and a senior
trader was charged with offences of encouraging clients to trade CFD’s in relation to two
of the stocks. The advice to the client was given based on insider knowledge which was
not yet known to the general public (FSA, 2010)
A total of seven takeovers were traded ahead of their official announcement and the
individuals involved with insider dealings were sentenced contrary to section 52 of the
Criminal Justice Act. (FSA, 2010)
Typical scenarios of inside traders
A typical example of such an insider dealing is that of a pre announced merger. Mergers
usually means that the share price goes up once announced. However, shares purchased by
a director in anticipation that the share value will rise allowing him/her go achieve a capital
gains profit. Another example is that of a manager, who would naturally be privy to
information which was not yet released to their shareholders, of a mining and exploration
firm. They have found a new exploration site but news of this has not yet reached the
shareholders, the manager purchases shares in the knowledge that once that information
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has been released the value of those shares will rise because of the purchasing power
enabled by the shareholders.
Bhattacharya et al (2000) stated that there has been evidence that emerging markets are the
most inefficient markets because they are most prone to information leakages prior to such
information officially being released. Bhattacharya et al (2000) also stated that the stock
markets in Mexico, as an example of this, did not react to corporate news, to which they
concluded the price had already fully adjusted to this news because it was leaked and
everyone traded on it, so there was no market reaction on the day of the official news
release. Fuentes and Maquieria (2001): Sultz (2005) and Guriev et al (2003) supported this
point in that other studies on emerging economies are prone to widespread insider trading
where insiders exploit their knowledge to obtain excessive returns. The aim of this study is
to prove or disprove this hypothesis.
In summary, if the markets are strongly efficient, then there is little point in the financial
manager trying to mislead the markets because:
The market will decide on the cost of capital (also known as the required rate of
return) and:
that the market will see when a firm is attempting to ‘window dresses their annual
accounts in order to place an optimal spin on the share price.
Other implications are that financial managers will be wasting their time in looking to
acquire companies which look undervalued in terms of their share capital because the
market will have ‘priced in’ all fundamental and technical information (depending on how
efficient the market is) about takeover target (ACCA, 2010)
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Research: Implications, Aim and Methodology
Research Aim
This paper aims to come to a conclusion as to whether the stock markets (capital markets)
are as efficient as the US stock exchanges which are considered to be very efficient
compared to those of emerging markets.
The aim of this research is to determine the accuracy and question the literature
surrounding the topic of the presence of insider trading in emerging markets where it is
said the markets are less efficient and more prone to informational leakages. Furthermore,
this information will be used to measure the rate of abnormal returns made by investors if
they trade on inside information. The broad basis of this study is to test for possible
evidence of insider trading, which is trading on information prior to its official release.
This is a test to see if the buying and selling decisions yield abnormal returns and if this
provides a signal for other market participants.
A great deal of literature insists that insider trading is a significant barometer to broad
market shifts in sentiment. Very few studies have been conducted outside of the US but
Bhattacharya, (2000) states that the Mexican Stock Markets, as well as the US and the UK
markets have encountered abnormal returns from the buying and selling decisions carried
out by investors and it is the aim of this study to give support of Bhattacharya’s theories or
to disprove this.
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Research Implications
Although there has been some ambiguity as to the exact definitions of the three types of
market efficiency the author will use the definitions of market efficiency taken from the
ACCA (2010) textbook.
Research Methodology
Data was collected on the adjusted closing prices of two companies listed on a stock
exchange from 2011-2012 as well as the adjusted closing prices of the corresponding stock
exchanges themselves. Any stocks where is has proven difficult or impossible to obtain
will be taken out of the sample.
If there is an association between market efficiency and market, we will then apply the
Standard Event Methodology to come to a reasonable conclusion as to which markets are
strongly efficiency and which are not. The study will be Standard Event Methodology
Study, or an Event Study which averages the cumulative performance of stocks overtime
and will be based on the standard linear regression analysis formula y=mx + c in order to
come to the expected daily returns from share (Ri). This will be measured from a specified
number of periods (days) before an event to a specified number of periods after the news
release.
For the purpose of this research, we will use the definitions taken the ACCA (2010
textbook for clarification on market efficiency.
Historical prices were obtained, for the study, from the ‘YahooFinance’ Service where it
posts the historical pricings for financial securities and their stock exchanges. These were
downloaded onto a spread sheet. A year’s worth of prices was obtained.
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Two major news releases were then picked which fell into the time window of between 6th
May 2011 and 6th May 2012. For Apple Inc. the news release of the new iPad was selected
for the study (Apple. Inc, 2012). The release was on 7th March 2012. Cola Ferma posted a
6% profit increase in the fourth quarter of their financial year ending 29th February 2012
(Reuters, 2012). These news releases were placed on the excel sheet and a ten day window
was placed around the date of the news release.
The daily returns for each share, with a maximum holding time of 24 hours was based on
the adjusted closing price for each day was then calculated using the following formula:
Daily Returns (D(r)) = (P1 – Po)/Po
The following was then calculated using the formulae available on Excel applied the prior
150 days before the 21 day event window (21 days being the ten days before the news
release, plus ten days after the news release, plus the day of the news release).
Intercept (=INTERCEPT)
Slope (=SLOPE)
R Squared (=RSQ)
Standard Error (=STEYX)
A table was then produced to calculate the following based on the 10 day event window.
The results are on the two tables taking up appendices one and two:
Er Expected Return INTERCEPT+SLOPE*MROR y = mx + c will return the same value
Ar Abnormal Return Ri – (y = mx + c) or ErCAR Cumulative Abnormal Return CAR + ART-
test
Statistical Significance Test AR / SE
Standard Linear Regression Values
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The values for the daily returns within (-150) window prior to the event window returned
the following values in Excel:
Apple Inc Coca-Cola
Slope (=SLOPE) 0.686767 -0.064201866
Intercept (=INTERCEPT) 0.002512 0.000727636
Standard Error (=STEYX) 0.014424 0.022132762
Assumptions
It has been assumed that the investment portfolios held by the market participants of both
stock markets have been diversified in such as way so that no unsystematic risk was a
feature in any portfolios. This means that the risks that such portfolios were carrying were
equal to the overall market risk, or what is known as the systematic risk, this cannot be
diversified away because this risk is determined by external economic pressures such as
interest rates and political events. Having an undiversified portfolio carries more risk and
therefore makes way for the possibility for abnormal returns which could affect the results
of the study that could show readings imitating the presence of insider trading when in fact
they are not.
Data Analysis
Observations
Looking at the data from Apple vs the NASDAQ, the presence of abnormal returns
compared to the expected returns from the share are relatively minimal before the news
release date and significantly negative at day (-2). In fact investors reacted very negatively
to the news this was released on day (0), however, upon further research it was revealed
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that Korean-based Samsung, an electronics manufacturer, filed a lawsuit against Apple on
the same day on the basis of copyright infringement issues. This would have driven the
share price down, bearing in mind that these prices were calculated on the adjusted daily
closing prices which mean that these were the prices at the close of the trading sessions but
takes the average of the high, low and closing prices as well. However it was also observed
that there was a significant spike on ay (5) meaning that investors achieved large abnormal
returns compared to the market average.
One of two reasons for this: one could be that the news of Apples new product release
were realised by the market and thereby driving the share price upwards and giving a
signal to investors (thereby giving the markets an inefficient characteristic), or that some
insider information was released about the company concerning another important
announcement which would have the power to influence the investors’ decision to
purchase the stock and thereby creating an imbalance in the supply and demand of Apple
shares on the stock markets.
Large positive returns followed by negative spikes in the abnormal returns could be
associated with the volatility of the markets because large negative returns were generated
after the day (5). This was also the case on the chart which shows the expected returns
from the individual share versus the abnormal returns generated by those shares where
after the news release, large abnormal returns exceeded the expected returns with, again,
the large volatile peaks and troughs of the abnormal returns compared to the expected
returns of the share price swings.
Looking at both charts is evident that investors react to the information which invalidates
the null hypothesis because investors do, in fact, buy and sell stocks based on company
fundamentals broadcasted but in some cases not as much as in previous days. A lawsuit
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would cause the markets to increase their volatility because there is uncertainty of how the
outcome will play as the judges will make their decision. Investors here were clearly
anticipating Apple having to pay out large sums of money in compensation to Samsung
over the copyright infringement, reducing Apples cash flows and, if investors are rational
(which is a characteristic of an efficient market), then they may well sell their shares as
was experienced in the negative abnormal returns generated on day (6).
Observing the Coca-Cola returns versus the Mexican Stock Exchange expected returns
where extremely wide volatile stings in the expected market returns. Market volatility is
associated with an inefficient market because of the fewer investors willing to trade on
such markets.
Looking at the charts it is very evident that investors did react to the news of their 28%
profit increase because there are significantly large spikes on day (2) but was slightly
delayed after the news release, which could give the markets in Mexico a slight
inefficiency in pricing in all available information.
However, like with Apple on the NASDAQ exchange, some insider information could
have been of another nature and so investors traded on this information by purchasing the
stock and giving a signal to investors, whom are not insiders, to do the same.
This would be a good point to mention that when looking back at the arguments for and
against insider trading, it was argued by Herzal & Katz, (1987), that insider trading is a
good thing because it not only prices all information about the company into its pricing
mechanism, but this gives a signal to other investors whom are not insiders to trade the
stock, by the use of technical indicators such as volume indicators, which, in increasing in
volume will mean that there is a bullish drive behind the price, will mean that a capital gain
can be achieved, therefore there is no loss and therefore no fraud is not committed. This
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could be seen as the case with Coca-Cola and as with at day (2) abnormal returns in excess
of the market average were achieved.
Another possible cause for this would be that investors cannot achieve abnormal returns if
their investment portfolios’ unsystematic risk was equal to the systematic risk, in other
words, were as diversified as possible. So it could be assumed here that portfolios were not
as diversified as they could have been and so therefore, abnormal returns could have been
achieved here.
Conclusion
It remains inconclusive as to whether insider trading has taken place on the Mexican Stock
Exchange, prices certainly increased and thus generating a return to buy-side portfolios but
this can also be accounted for a range of other factors, such as another news release which
had more power to drive up the price of the stock, than the news release which we took as
as the focus of our study. Both news releases in general have the power to at least influence
an investors’ decision to purchase the stock: Apple released a new product and therefore
this would naturally be anticipated a profit increase from the sales generated by the new
product or even in anticipation of dividends, however there was no literature found
documenting Apple ever doing paying out dividends..
There is a similar story to CoCo-Cola in Mexico: a 6% profit increase means an increase in
company valuation, increased asset efficiency and return on capital employed, a relatively
low cost of capital due to an optimum capital structure, as well as the obvious: increased
sales are just a few factors which may determine an investor to act positively in terms of
the purchasing the stock and becoming a shareholder and owner of a relatively profitable
company when set against their industry averages.
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A very large spike was observed on day (2) which may mean that the information took
longer to reach investors before they bought the stock. This means that the markets are not
as efficient as could be because it took a significant amount of time to give the company a
fair stock market valuation. They did react positively compared with the previous day
when negative excess returns were present.
The significant abnormal returns from Apple Inc. were achieved after the news release of
the New Generation iPad and before this; returns were relatively subdued in contrast. This
may indicate that insider trading is very minimal on the NASDAQ stock exchange, but
investors have reacted to the news, especially compared to the day before the news release
where there negative abnormal returns.
In summary, although there was evidence that only a small amount of insider trading
taking place on both stock exchanged, there is a more obvious theme here and that is the
time it took for news to reach investors: on both graphs there were significant spikes where
investors purchased the stock a few days after the news events were released and thus
giving the markets a low efficiency characteristic even though the price has reflected the
information that, by then, had been made public.
Another point to make is that there were spikes of insider trading prior to the news released
which supports Bhattacharya’s viewpoint of the Mexican Stock Exchange being a low
efficiency stock market in that the research presented here showed a very low reaction on
the day of the news release but a significant spike a few days before, and so this could have
been due to an information leakage to which investors acted upon and so the price was
already reflecting the news release when the news was announced and therefore making it
a ‘non-event’ as far and price movements were concerned.
Further Reading, Research and Development
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This dissertation only looked at one company on one stock exchange in one developed
economy (the USA) and another one in a developing nation (Mexico). If one wishes to
develop a stronger case of evidence to support this very debatable and controversial topic
that is insider trading and the efficient market hypothesis, then a series of studies would
have to be competed in order to derive a varied range of companies, economies and stock
changes. Studying just one per economy is not enough.
This is because this makes room for any anomalies in the data and collecting additional
data will aid to determine which data is an anomaly and which aren’t when compared to a
range of examples. There have been very few studies of this nature outside of the USA and
so one could test a range of developing economies of which are outside of the USA. This is
mainly because such data has proven to be quite difficult to obtain in the past, however
with the invention of the internet more information than ever is at anyone’s fingertips
providing they have a laptop and a connection. Especially when studying the Middle
Eastern economies as it is against the Muslim religion to trading in these markets as this
constitutes a gambling and involves interest payments.
However, these studies could aid regulators to better understand what exactly is going on
in the markets domiciled in their countries, and because in some cultures there is a large
degree of bribery connected with the disclosing of insider trading, regulators can have a
better chance in changing the way in which the markets are facilitated and the resources
used.
Furthermore, it is possible that the dates which were used for the news released may not
have been the dates at which the news was actually released, and was in fact the date at
which the press release was written, which would affect the data. The dates were taken as
the dates mentioned on the news releases themselves, however, this may be a few days
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A Comparison of Stock Market Efficiency between the US and Emerging Markets
before and which could explain the significant returns from the reaction of the investors a
few days before day (0) which would disprove that insider trading is taking place in both
Mexico and the USA.
Another factor which could be changed was the holding period. The holding period which
this research used was one day. However, longer holding periods could be analysed to
compare excess returns over different holding periods.
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Appendices (1)
The Expected Returns (Er), Abnormal Returns (Ar), the Cumulative Abnormal Returns
(CAR) and the Abnormal Return T-Test (ART-Test) for Apple Inc
Er Ar CAR ART-Test
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-0.00048 -0.02716 -0.02716 -1.227280.001424 0.000496 -0.02667 0.0223950.000336 -0.00134 -0.02801 -0.060550.000131 0.01165 -0.01636 0.5263870.001678 -0.00746 -0.02381 -0.33683-0.00089 -0.00547 -0.02928 -0.247010.002889 -0.00389 -0.03317 -0.175940.000807 -0.00145 -0.03462 -0.065370.000517 -0.0007 -0.03532 -0.031620.000334 -0.01196 -0.04728 -0.540350.000362 0.008344 -0.03894 0.3769910.000235 0.001969 -0.03697 0.0889670.00029 0.022156 -0.01481 1.0010650.000267 -0.0224 -0.03721 -1.012070.000931 -0.00221 -0.03942 -0.100020.000549 0.000919 -0.03851 0.041510.002684 0.003821 -0.03468 0.1726350.00023 0.001591 -0.03309 0.071873-0.00255 -0.01281 -0.0459 -0.578620.002311 -0.01911 -0.06501 -0.863220.000246 0.005855 -0.05915 0.264528
Appendices (2)
The Expected Returns (Er), Abnormal Returns (Ar), the Cumulative Abnormal Returns
(CAR) and the Abnormal Return T-Test (ART-Test) for Coca-Cola Mexico
Er Ar CAR ART-Test-0.00107 -0.00244 -0.00244 -0.16924128
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SLOPE (M) 0.686767INTERCEPT (C) 0.002512STANDARD ERROR 0.014424
A Comparison of Stock Market Efficiency between the US and Emerging Markets
0.008087 -0.00156 -0.004 -0.107985040.004085 0.007573 0.003574 0.525021050.003071 0.003342 0.006916 0.23166970.007282 0.011072 0.017988 0.76761842-0.00206 0.015186 0.033175 1.052846010.007623 -0.00388 0.029294 -0.269071-0.00042 0.001728 0.031022 0.11979569-0.00342 -0.01863 0.012394 -1.29140843-0.00684 0.001396 0.01379 0.096786250.008499 -0.00769 0.006102 -0.533011240.010637 0.010656 0.016758 0.738751550.006656 -0.00079 0.015969 -0.05465460.001437 0.011091 0.027061 0.768932430.015453 0.013714 0.040774 0.950740540.002705 0.035106 0.07588 2.433803160.006045 -0.01286 0.063017 -0.891782780.002263 -0.00225 0.060771 -0.155709270.007696 0.018825 0.079596 1.305111070.001582 0.006503 0.086099 0.450839640.002774 -0.00848 0.077615 -0.58816368
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SLOPE (M) -0.064201866INTERCEPT (C) 0.000727636STANDARD ERROR 0.022132762
-10 -9 -8 -7 -6 -5 -4 -3 -2 -1 0 1 2 3 4 5 6 7 8 9 10
-0.03
-0.02
-0.01
0
0.01
0.02
0.03
0.04
Apple Returns vs The NASDAQ Market Average
RmAr
Retu
rns
A Comparison of Stock Market Efficiency between the US and Emerging Markets
-10 -9 -8 -7 -6 -5 -4 -3 -2 -1 0 1 2 3 4 5 6 7 8 9 10
-0.04
-0.03
-0.02
-0.01
0
0.01
0.02
0.03
0.04
0.05
0.06 Coca-Cola Abnormal Returns vs. Market Average
RmAr
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