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.

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Ba (Hons.) Dissertation

  1. 1. University of East Anglia | City College Norwich BA (Hons.) Business Management Word Limit 10,000A Comparison of StockMarket Efficiencybetween the US andEmerging MarketsDissertationThe purpose of this study is to test and compare theefficiency of stock markets in emerging economiescompared with those in developed markets. If a stockmarket is ‘efficient’, it is said that the price of a stockreflects all information concerning a company’sfundamentals (such as earnings reports, news ofmergers and acquisitions or pre dividendannouncements to name a few) weather suchinformation is available to the general public or hasyet to be released to the general public, or morespecifically, the shareholders.
  2. 2. A Comparison of Stock Market Efficiency between the US and Emerging MarketsContents PageLearning Outcomes 3Summary 3Literature Review 4What are the Stock Markets 8Three categories of market efficiency 9Key Features of an Efficient Market 11The Efficient Market Hypothesis 11How do Efficient Markets Benefit Investors and Firms? 12Definitions of Insider Trading 13Who are Insider Traders 15Typical Insider Trading Scenarios 16Research Aim, 18Methodology 19Implications 19Assumptions 21Data Analysis: Observations 21Conclusion 24References 28 BA (Hons) Business Management | University of East Anglia Page 1
  3. 3. A Comparison of Stock Market Efficiency between the US and Emerging MarketsLearning 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.SummaryThe purpose of this study is to test and compare the efficiency of stock markets inemerging 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 acompany’s fundamentals (such as earnings reports, news of mergers and acquisitions orpre dividend announcements to name a few) weather such information is available to thegeneral public or has yet to be released to the general public, or more specifically, theshareholders.The focus of this study will be to determine that there may be a possibility, or not, of thepresence of insider trading taking place in emerging economies by testing to see ifinvestors within those stock markets achieve significantly abnormal returns compared withthe stock market average. This report will further explore the laws and regulationscurrently in force in two economies: the United Stated and Mexico, of which have veryBA (Hons) Business Management | University of East Anglia Page 2
  4. 4. A Comparison of Stock Market Efficiency between the US and Emerging Marketscontrasting economics and wealth in terms of poverty and productivity, and to see howwell they actually work in deterring insider trading today.Insider trading takes place where market participants are privy to and trade on informationwhich will not be released to the general public until a later date. This information willhave the power to move a stock price, such as a lawsuit or a profit announcement, and theaim will be to generate large profits for the market participant if they trade on thisinformation. The aim of this study is to come to a conclusion as to how efficient themarkets 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 nationsregulate insider trading activities but in varying degrees in terms of the severity of thepunishments and penalties that would follow when prosecution is brought before the law(Bhattacharya &Daouk, 2000). The research of Bhattacharya &Daouk, (2000) concludedthat the regulation of insider trading appears to prevent those with information advantagefrom 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 variouscharacteristics in stock markets, will be applied here to, firstly, see if investors do react tonews broadcasts concerning the companies of which are being traded on the various stockexchanged across the world: this is classed as the ‘null hypothesis’ or is otherwise knownas the ‘hypothesis of the status quo’, or if investors do not react to such information: thiswill be classed as the alternative hypothesis. Secondly, the Event Study, as this is alsoknown as, will test to see if investors have achieved significantly abnormal returns bymeasuring the difference between the expected returns (which is calculated using thestandard linear regression analysis) and the abnormal daily returns from the individualshares, prior to such information being made public.BA (Hons) Business Management | University of East Anglia Page 3
  5. 5. A Comparison of Stock Market Efficiency between the US and Emerging MarketsThe right trading environment to trade on insider information is only when the marketspossess semi-form efficiency characteristics, and that financial managers have insideinformation or knowledge, can the right environment be created for managers to gainadvantage and to exploit such insider information in order to realise excessive or abnormalreturns compared to the market average (ACCA, 2009).Insider trading is not easy to estimate because people are reluctant to report it because ofthe severe penalties in force if this was detected (Bris, 2005, p.269), and very few testsoutside of the US have been conducted at the time or writing, however, one research paperwas found on the Athens ( website which focused on the presence ofinsider trading which was detected by applying the same event study, as this report will useto test for insider trading in Mexico and the US, on the Istanbul Stock Exchange. The paperwas written by Dogu, Karacaer and Baha Karan, (2010) titled‘Empirical Testing of InsiderTrading in the Istanbul Stock Exchange’. Research carried out on the ISE concluded therewas evidence of insider trading present by showing that abnormal returns were achievedten days before the news release on a company which was listed on the exchange. This waswhere buyers started purchasing stocks when the information in question was leaked to thepublic. After the news was released, excess returns failed to break through the positiveboundary (Karacaer and Baha Karan, (2010).Literature ReviewArguments for and against insider tradingThe 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 ExchangeAct (1934), (SEC, 2012, Brody &Perri, 2011). The act goes even further by not onlyaddressing the corporate insiders on this act, but also to those who are known asBA (Hons) Business Management | University of East Anglia Page 4
  6. 6. A Comparison of Stock Market Efficiency between the US and Emerging Marketsconstructive insiders, and outsiders who are made insiders by a tip-off or through personalor professional relationships. Constructive insiders are those who are informed by insiderswhom have a duty to keep such information personal until the time arises when this isofficially released into the public domain (Bris, 2005)However, despite the enormous amount of legislation around insider trading, argumentsare still in fever pitch amongst scholars and practitioners whereby they argueon one side ofthe coin that insider trading should be revoked, and on the other side (mainly theregulators) state that insider trading is morally wrong, it deters investors and destabilizesinvestments. It is not surprising then that this is the view of the Securities ExchangesCommissionwhich is established to protect investors and maintain and fair and levelplaying field in US-Domiciled money and capital markets (SEC, 2012).A question of theftVelasquez (2002) talks about the two main arguments against insider trading, stating thatinsider trading is extremely harmful to the markets. Insider trading trades on informationwhich is stolen and that such information belongs to the corporation. Any asset that is usedby 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 belongsto the company, so any exploitation of such privy information carried out by anyone otherthan the company, this could be argued as theft.A question of FairnessThe second argument questions the fairness of advantage of an insider having informationor knowledge over another investor. It is often the case that two parties do not have equalknowledge when coming to a transaction because of the differing levels of due diligenceand analysis, however with insider trading, one member of that party has no way ofBA (Hons) Business Management | University of East Anglia Page 5
  7. 7. A Comparison of Stock Market Efficiency between the US and Emerging Marketsobtaining insider information regardless of how much research or due diligences has beencarried out on a particular stock prior to trading, unless that individual was in an extremelyprivileged 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 hason the market itself: it reduces the size of the market because investors are reluctant totrade in a market which has high levels of insider trading. When fewer people trade in amarket, 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 thatno 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 tradingis not fraudulent because there is no loss. This argument is supported by the mechanism ofbuyers and sellers that if a buyer is buying stocks based on inside information a seller canbenefit 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 whowill increase the spread, or the costs associated with trading the markets incurred by themarket participants, to maintain long-term profitability. This operates as a tax to marketparticipants and increases a disincentive to traders not to trade. This is also the mainargument of the regulators.Further arguments against the practice of insider trading suggest that this discouragesinvestment as well as damaged corporate value due to non-insiders facing an adverseselection problem, (Manove, 1989: Ausubel, 1990: Fischer, 1992). Furthermore, Brudney,(1979): Easterbrook, (1985): Glosten, (1989):&Maug, (1995,2002), state that thisdiminishes investor confidence and damages the integrity of the capital markets.BA (Hons) Business Management | University of East Anglia Page 6
  8. 8. A Comparison of Stock Market Efficiency between the US and Emerging MarketsA point put forward by Bainbridge, (1988) states that the ban of insider trading reduces themarket’s efficiency as well as managers’ compensation. Manne (1966) supports this byarguing that the prohibition of insider trading causes the stock markets to become lessefficient (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 Economicslaureate FriedmanMiller supports insider trading by stating that ‘you want more insider trading, not less andwanting to give the people who are aware about any company deficiencies (insiders) anincentive 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 insidertrading by saying that any restrictions should be revoked because this practice thus allowsprivate information to very quickly become incorporated into the stock pricing mechanismwhich will ultimately lead to that stock becoming more informationally efficient.There is also no violation of rights for non-insiders because they, again, achieve capitalgain 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 beenviolated then there is nothing unethical about this practice. Insider trading has no victimsbecause any transactions carried out by the insider moves the stock price in the direction ofthe preferential information and the counterpart will benefit from selling the stock at thehigher price and thus achieving a capital gain from the price increase.They also give a truerreflection of the market price of a stock based on all information regardless of its publicavailability – strong form efficiency- and also the opportunity to generate more capitalgains and income taxation for the economy, (Herzal& Katz, 1987)BA (Hons) Business Management | University of East Anglia Page 7
  9. 9. A Comparison of Stock Market Efficiency between the US and Emerging MarketsFinnerty (1976) says that the regulation of insider trading exploits market efficiency as itsstrongest form as the stock price reflects all information, preferential included and hencethe insider pushes the stock price faster towards a better reflection of the fundamentals ofthe company.Hague et al, (2004) stated that a key characteristic of Middle Eastern stock markets are thatthey hold low liquidity, meaning less traders in the market. Bhattacharya et al (2000) alsosays 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 publicdomain, this is already ‘priced in’ to the stock. However, this contradicts what others havesaid about a market being weak-form efficient: in the ACCA (2009) it says that a weakmarket’s prices only reflect past price movements where a strongly efficient marketreflects all past price movements and includes all publically available information as wellas insider information as well.What are the Stock Markets?Firstly, the stock markets, or more specifically a ‘market’ comprises of a mixture of buyersand sellers of stocks, bonds, commodities and foreign exchange instruments whose price atwhich those instruments are purchased and sold at being determined by supply and demandforces, (Kahn, 2006). However, the prices are only determined by supply and demandwhen 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 bearsBA (Hons) Business Management | University of East Anglia Page 8
  10. 10. A Comparison of Stock Market Efficiency between the US and Emerging Markets 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 efficiencyMarket 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 reflectedby past price trends: Fama (1970) in fact states that all financial assets traded on a stockexchange 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 bypast price trends and all publically available information. The strong form efficiencytheory applies to markets where the current price reflects past price movements, allpublically available information and private information as well. In other words, themarket is said to be efficient and ‘perfect’ when the price represents a fair and accurateeconomic picture of a company by the company’s stock market valuation. It is alsoimportant to note that, although efficient market pricing represents all availableinformation, it is about timing of the changes in price as new information becomesavailable. This will create an imbalance of supply and demand of such shares as newinformation becomes known to the public (ACCA, 2010)Efficient market prices will change quickly to reflect new information where inefficientmarkets will take a longer period of time to adjust to the new information as this graduallybecomes known and acted upon by different market participants through the course of timeor that the information has been leaked and acted upon prior to its official release (ACCA,BA (Hons) Business Management | University of East Anglia Page 9
  11. 11. A Comparison of Stock Market Efficiency between the US and Emerging Markets2010) This was evident in the research carried out on the Mexican and the US markets aswell.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 abnormalpositive returns using publically available information. Dimson and Mussavain (1998) saythat trading on available information through legit channels fails to provide an abnormalprofit.Kahn (2006) sums up the existence of trends in an imperfect market resulting in uneveninformation dissemination across all the market participants. The price movements in thesemarkets are the reason as to why traders trade the market: to take advantage of the pricemovements and generate a profit.Weak-form efficient markets – based on price movements solely – are traded by technicalanalysis. This analysis is the opposite of a fundamental trader where information sourcesfrom earnings reports, news broadcasts and annual reports are used to determine how abusiness will fare in the future and therefore, weather to purchase a stock. Technicalanalysis, Kahn (2006) puts forward the question of how traders can possibly rely on suchdata which is subject to constant revisions. The role of technical analysis is to assesscurrent prices and where they are likely to go, based on past price movements governed bythe 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 mobilizedomestic savings.BA (Hons) Business Management | University of East Anglia Page 10
  12. 12. A Comparison of Stock Market Efficiency between the US and Emerging MarketsKey theoretical features of an efficient marketThere are key features of an efficient marketplace and according to ACCA, (2010) thesekey features, or characteristics of such efficiency are; the price of a security reflects allinformation available in the public domain and that the share price will change quickly toreflect newly released information, secondly, no individual dominates the market, investorsare rational, there are low or no costs to acquire information, and that transaction costs (orspreads) are not so high as to discourage buyers and sellers from participating in themarkets. Dimson and Mussavain, (1998) state that if markets are sufficiency competitivethen investors cannot expect to achieve superior returns from their portfolios whilstimplementing their investment strategies.Dimson and Mussavain, (2000) say that the term ‘efficiency’ describes a market which hasall relevant information reflected in the price of financial assets. This is an important pointto highlight because many economists use the term ‘efficiency’ when they refer to‘operational efficiency’ which describes the way in which resources are used to facilitateand 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 astock.The efficient market hypothesis (EMH)The EMH applies where all prices react quickly to all available information and sotherefore investors cannot obtain higher than average returns from a well-diversifiedportfolio. Dimson&Mussavian, (2000) further support this by stating that if capital marketsare sufficiently competitive, then investors cannot achieve superior profits from theirtrading strategies. Fama (1976 p.113) talks about markets being efficient at processing newinformation and that all prices will reflect all available information.BA (Hons) Business Management | University of East Anglia Page 11
  13. 13. A Comparison of Stock Market Efficiency between the US and Emerging MarketsKavussanos et al (2008) talks about perfect markets as those who price all new informationinto their pricing mechanism simultaneously, however, lead-lag relationships, on the otherhand, 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 minimumrequired 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 (ifthe firms pay dividends). The effect of this is the rise in the share price as a result of thenew imbalance of supply and demand; in this case demand exceeds supply which causes arise 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 thecost of equity as a percentage using the dividend growth model, which is in turn used as adiscount factor to apply to investment appraisals carried out by the firm when makingfuture investment decisions. This discount factor is used to discount against expectedfuture earnings and cash movements (ACCA, 2010)The same applies if the opposite happens in that if the firm generates negative NPV’s fromtheir cash movements, its shareholders will be aware of this happening and so they will sellthe stock, therefore drive the stock price downwards and giving a fair stock marketvaluation 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 higherreturn on their investment (ACCA, 2010)BA (Hons) Business Management | University of East Anglia Page 12
  14. 14. A Comparison of Stock Market Efficiency between the US and Emerging MarketsDefinitions of Insider TradingInsider trading is the trading of stocks and shares based on information of which is not yetavailable to the general public, this is information which might influence the investorsdecision 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 participantsor spectators. These can be company directors, investment managers, big shareholders orcompany employees, brokers or analysts. So it is therefore obvious that these groups havea monopoly over other investors which do not have such insider information, and if allmarket participants could legally trade on such knowledge these would have a powerfuladvantage of gaining excessive returns over the typical investor.Misra, (2011, p 163) state that an individual would chose to indulge in inside trading togenerate profits or to avoid losses outside the normal rational decisions for buying andselling securities based on publically available information. However this is only possiblewith the possession of non-public, price sensitive information.O’Hara (2001, p1047) stated that an insiders can be classed as any group or person thatgains such privileged information and comes under the categories of employees, managersor directors of a company. Individuals can become insiders in a more intimate capacitysuch as through family or friends, or close but external business associates. Also those whohave a contractual linkage such as suppliers (such as printers of company Annual andFinancial Statements) could be deemed to be insiders if they copy or withhold informationthey were privileged to see or that they would see such information anyway in order toconduct their job.Haggerty and Fishman, (1995) state that insiders have also manipulated the markets byannouncing a piece of news, or several news items, to the public which has the potential toBA (Hons) Business Management | University of East Anglia Page 13
  15. 15. A Comparison of Stock Market Efficiency between the US and Emerging Marketsmove a stock price and therefore create opportunities for profit potential for upcomingtransactions.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 highactivity of insider trading, they are also aware that there are a small handful of peoplewhom are prepared to act in an unlawful way when participating in the financial markets.Insider trading raises costs to everybody else, increases volatility, and underminesconfidence. According to the FSA, (2011) financial institutions are required to submit theirtransactions by the close of business on the next day after the transaction took place. Thisenables the FSA to monitor and detect any possible market abuse activities from thesefirms. For instance, firms are required to submit all transactions taking place on theMonday by the close of business on the Tuesday. Failure to do this results in companiespaying very hefty fines! For example, the London-based spread-betting firm City Index( failed to submit approximately 55,000 transactions and reportedaround 1,970,000 transactions incorrectly by errors in the relevant data fields. They werefined £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 thatmonopoly over other investors is damaging to the market itself. The enforcement of a banof insider trading increases confidence and trust in these markets which will encourageinvestors 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 monitoringthe markets with the aim of assessing market cleanliness. They have seen that stock pricesBA (Hons) Business Management | University of East Anglia Page 14
  16. 16. A Comparison of Stock Market Efficiency between the US and Emerging Marketshave risen before the announcement of an M&A which suggest that informed trading hastaken place.A key area of focus is on the investment banks: more specifically the relationship betweenthese investment banks and their clients. This is the case because there is the risk that theclient can become an insider when he/she is made aware of an up and coming deal on aparticular company or stock.Who are inside traders?The Code of Market Conduct states than an insider is classed as a ‘regular user’ and is onewho is a ‘reasonable’ person who deals regularly with and has an intimate understanding ofhow the financial markets operate. There is also a test for a ‘reasonable person’ whichemploys 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 moresituations: 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.BA (Hons) Business Management | University of East Anglia Page 15
  17. 17. A Comparison of Stock Market Efficiency between the US and Emerging Markets Someone who has access to such information as a result of their employment, duties or professionTo put this into a real-life situation there have been many cases where individuals andcompanies have been prosecuted and sentenced for insider dealings. In 2010 fiveindividuals, including two former directors and a former senior trader employed by acompany 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 offencesof trading ahead of three separate takeover announcements, a former employee wascharged with one offence of trading ahead of one takeover announcement and a seniortrader was charged with offences of encouraging clients to trade CFD’s in relation to twoof the stocks. The advice to the client was given based on insider knowledge which wasnot yet known to the general public (FSA, 2010)A total of seven takeovers were traded ahead of their official announcement and theindividuals involved with insider dealings were sentenced contrary to section 52 of theCriminal Justice Act. (FSA, 2010)Typical scenarios of inside tradersA typical example of such an insider dealing is that of a pre announced merger. Mergersusually means that the share price goes up once announced. However, shares purchased bya director in anticipation that the share value will rise allowing him/her go achieve a capitalgains profit. Another example is that of a manager, who would naturally be privy toinformation which was not yet released to their shareholders, of a mining and explorationfirm. They have found a new exploration site but news of this has not yet reached theshareholders, the manager purchases shares in the knowledge that once that informationBA (Hons) Business Management | University of East Anglia Page 16
  18. 18. A Comparison of Stock Market Efficiency between the US and Emerging Marketshas been released the value of those shares will rise because of the purchasing powerenabled by the shareholders.Bhattacharya et al (2000) stated that there has been evidence that emerging markets are themost inefficient markets because they are most prone to information leakages prior to suchinformation officially being released. Bhattacharya et al (2000) also stated that the stockmarkets in Mexico, as an example of this, did not react to corporate news, to which theyconcluded the price had already fully adjusted to this news because it was leaked andeveryone traded on it, so there was no market reaction on the day of the official newsrelease. Fuentes and Maquieria (2001): Sultz (2005) and Guriev et al (2003) supported thispoint in that other studies on emerging economies are prone to widespread insider tradingwhere insiders exploit their knowledge to obtain excessive returns. The aim of this study isto prove or disprove this hypothesis.In summary, if the markets are strongly efficient, then there is little point in the financialmanager 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 toacquire companies which look undervalued in terms of their share capital because themarket will have ‘priced in’ all fundamental and technical information (depending on howefficient the market is) about takeover target (ACCA, 2010)BA (Hons) Business Management | University of East Anglia Page 17
  19. 19. A Comparison of Stock Market Efficiency between the US and Emerging MarketsResearch: Implications, Aim and MethodologyResearch AimThis paper aims to come to a conclusion as to whether the stock markets (capital markets)are as efficient as the USstock exchanges which are considered to be very efficientcompared to those of emerging markets.The aim of this research is to determine the accuracy and question the literaturesurrounding the topic of the presence of insider trading in emerging markets where it issaid 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 ifthey trade on inside information. The broad basis of this study is to test for possibleevidence 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 thisprovides a signal for other market participants.A great deal of literature insists that insider trading is a significant barometer to broadmarket shifts in sentiment. Very few studies have been conducted outside of the US butBhattacharya, (2000) states that the Mexican Stock Markets, as well as the US and the UKmarkets have encountered abnormal returns from the buying and selling decisions carriedout by investors and it is the aim of this study to give support of Bhattacharya’s theories orto disprove this.BA (Hons) Business Management | University of East Anglia Page 18
  20. 20. A Comparison of Stock Market Efficiency between the US and Emerging MarketsResearch ImplicationsAlthough there has been some ambiguity as to the exact definitions of the three types ofmarket efficiency the author will use the definitions of market efficiency taken from theACCA (2010) textbook.Research MethodologyData was collected on the adjusted closing prices of two companies listed on a stockexchange from 2011-2012 as well as the adjusted closing prices of the corresponding stockexchanges themselves. Any stocks where is has proven difficult or impossible to obtainwill be taken out of the sample.If there is an association between market efficiency and market, we will then apply theStandard Event Methodology to come to a reasonable conclusion as to which markets arestrongly efficiency and which are not. The study will be based on the Standard EventMethodology Study, or an Event Study which averages the cumulative performance ofstocks 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 measuredfrom a specified number of periods (days) before an event to a specified number of periodsafter the news release.For the purpose of this research, we will use the definitions taken the ACCA (2010textbook for clarification on market efficiency.Historical prices were obtained, for the study, from the ‘YahooFinance’ Service where itposts the historical pricings for financial securities and their stock exchanges. These weredownloaded onto a spread sheet. A year’s worth of prices was obtained.BA (Hons) Business Management | University of East Anglia Page 19
  21. 21. A Comparison of Stock Market Efficiency between the US and Emerging MarketsTwo major news releases were then picked which fell into the time window of between 6thMay 2011 and 6th May 2012. For Apple Inc. the news release of the new iPad was selectedfor the study (Apple. Inc, 2012). The release was on 7th March 2012. Cola Ferma posted a6% 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 windowwas placed around the date of the news release.The daily returns for each share, with a maximum holding time of 24 hourswas based onthe adjusted closing price for each day was then calculated using the following formula:Daily Returns (D(r)) = (P1 – Po)/PoThe following was then calculated using the formulae available on Excel appliedthe prior150 days before the 21 day event window (21 days being the ten days before the newsrelease, 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*MR OR y = mx + c will return the same value Ar Abnormal Return Ri – (y = mx + c) or Er CAR Cumulative Abnormal Return CAR + AR T-test Statistical Significance Test AR / SE CCumulative ReturnBA (Hons) Business Management | University of East Anglia Page 20
  22. 22. A Comparison of Stock Market Efficiency between the US and Emerging MarketsStandard Linear Regression ValuesThe values for the daily returns within (-150) window prior to the event window returnedthe following values in Excel: Apple Inc Coca-Cola Slope (=SLOPE) 0.686767 -0.064201866Intercept (=INTERCEPT) 0.002512 0.000727636Standard Error (=STEYX) 0.014424 0.022132762AssumptionsIt has been assumed that the investment portfolios held by the market participants of bothstock markets have been diversified in such as way so that no unsystematic risk was afeature in any portfolios. This means that the risks that such portfolios were carrying wereequal to the overall market risk, or what is known as the systematic risk, this cannot bediversified away because this risk is determined by external economic pressures such asinterest rates and political events. Having an undiversified portfolio carries more risk andtherefore makes way for the possibility for abnormal returns which could affect the resultsof the study that could show readings imitating the presence of insider trading when in factthey are not.Data AnalysisObservationsLooking at the data from Apple vs the NASDAQ, the presence of abnormal returnscompared to the expected returns from the share are relatively minimal before the newsrelease date and significantly negative at day (-2). In fact investors reacted very negativelyBA (Hons) Business Management | University of East Anglia Page 21
  23. 23. A Comparison of Stock Market Efficiency between the US and Emerging Marketsto the news this was released on day (0), however, upon further research it was revealedthat Korean-based Samsung, an electronics manufacturer, filed a lawsuit against Apple onthe same day on the basis ofcopyright infringement issues. This would have driven theshare price down, bearing in mind that these prices were calculated on the adjusted dailyclosing prices which mean that these were the prices at the close of the trading sessions buttakes the average of the high, low and closing prices as well. However it was also observedthat there was a significant spike on ay (5) meaning that investors achieved large abnormalreturns compared to the market average.One of two reasons for this: one could be that the news of Apples new product releasewere realised by the market and thereby driving the share price upwards and giving asignal to investors (thereby giving the markets an inefficient characteristic), or that someinsider information was released about the company concerning another importantannouncement which would have the power to influence the investors’ decision topurchase the stock and thereby creating an imbalance in the supply and demand of Appleshares on the stock markets.Large positive returns followed by negative spikes in the abnormal returns could beassociated with the volatility of the markets because large negative returns were generatedafter the day (5). This was also the case on the chart which shows the expected returnsfrom the individual share versus the abnormal returns generated by those shares whereafter 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 expectedreturns of the share price swings.Looking at both charts is evident that investors react to the information which invalidatesthe null hypothesis because investors do, in fact, buy and sell stocks based on companyBA (Hons) Business Management | University of East Anglia Page 22
  24. 24. A Comparison of Stock Market Efficiency between the US and Emerging Marketsfundamentals broadcasted but in some cases not as much as in previous days. A lawsuitwould cause the markets to increase their volatility because there is uncertainty of how theoutcome will play as the judges will make their decision. Investors here were clearlyanticipating Apple having to pay out large sums of money in compensation to Samsungover 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 aswas experienced in the negative abnormal returns generated on day (6).Observing the Coca-Cola returns versus the Mexican Stock Exchange expected returnswhere extremely wide volatile stings in the expected market returns. Market volatility isassociated with an inefficient market because of the fewer investors willing to trade onsuch 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 slightlydelayed after the news release, which could give the markets in Mexico a slightinefficiency in pricing in all available information.However, like with Apple on the NASDAQ exchange, some insider information couldhave been of another nature and so investors traded on this information by purchasing thestock 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 andagainst insider trading, it was argued by Herzal& Katz, (1987), that insider trading is agood thing because it not only prices all information about the company into its pricingmechanism, but this gives a signal to other investors whom are not insiders to trade thestock, by the use of technical indicators such as volume indicators, which, in increasing involume will mean that there is a bullish drive behind the price, will mean that a capital gainBA (Hons) Business Management | University of East Anglia Page 23
  25. 25. A Comparison of Stock Market Efficiency between the US and Emerging Marketscan be achieved, therefore there is no loss and therefore no fraud is not committed. Thiscould be seen as the case with Coca-Cola and as with at day (2) abnormal returns in excessof the market average were achieved.Another possible cause for this would be that investors cannot achieve abnormal returns iftheir investment portfolios’ unsystematic risk was equal to the systematic risk, in otherwords, were as diversified as possible. So it could be assumed here that portfolios were notas diversified as they could have been and so therefore, abnormal returns could have beenachieved here.ConclusionIt remains inconclusive as to whether insider trading has taken place on the Mexican StockExchange, prices certainly increased and thus generating a return to buy-side portfolios butthis can also be accounted for a range of other factors, such as another news release whichhad more power to drive up the price of the stock, than the news release which we tookasas the focus of our study. Both news releases in general have the power to at leastinfluence an investors’ decision to purchase the stock: Apple released a new product andtherefore this would naturally be anticipated a profit increase from the sales generated bythe new product or even in anticipation of dividends, however there was no literature founddocumenting Apple ever doing paying out dividends..There is a similar story to CoCo-Cola in Mexico: a 6% profit increase means an increase incompany valuation, increased asset efficiency and return on capital employed, a relativelylow cost of capital due to an optimum capital structure, as well as the obvious: increasedsales are just a few factors which may determine an investor to act positively in terms ofBA (Hons) Business Management | University of East Anglia Page 24
  26. 26. A Comparison of Stock Market Efficiency between the US and Emerging Marketsthe purchasing the stock and becoming a shareholder and owner of a relatively profitablecompany when set against their industry averages.A very large spike was observed on day (2) which may mean that the information tooklonger to reach investors before they bought the stock. This means that the markets are notas efficient as could be because it took a significant amount of time to give the company afair stock market valuation. They did react positively compared with the previous daywhen negative excess returns were present.The significant abnormal returns from Apple Inc. were achieved after the news release ofthe New Generation iPad and before this; returns were relatively subdued in contrast. Thismay indicate that insider trading is very minimal on the NASDAQ stock exchange, butinvestors have reacted to the news, especially compared to the day before the news releasewhere there negative abnormal returns.In summary, although there was evidence that only a small amount of insider tradingtaking place on both stock exchanged, there is a more obvious theme here and that is thetime it took for news to reach investors: on both graphs there were significant spikes whereinvestors purchased the stock a few days after the news events were released and thusgiving the markets a low efficiency characteristic even though the price has reflected theinformation that, by then, had been made public.Another point to make is that there were spikes of insider trading prior to the news releasedwhich supports Bhattacharya’s viewpoint of the Mexican Stock Exchange being a lowefficiency stock market in that the research presented here showed a very low reaction onthe day of the news release but a significant spike a few days before, and so this could havebeen due to an information leakage to which investors acted upon and so the price wasBA (Hons) Business Management | University of East Anglia Page 25
  27. 27. A Comparison of Stock Market Efficiency between the US and Emerging Marketsalready reflecting the news release when the news was announced and therefore making ita ‘non-event’ as far and price movements were concerned.Further Reading, Research and DevelopmentThis dissertation only looked at one company on one stock exchange in one developedeconomy (the USA) and another one in a developing nation (Mexico). If one wishes todevelop a stronger case of evidence to support this very debatable and controversial topicthat is insider trading and the efficient market hypothesis, then a series of studies wouldhave to be competed in order to derive a varied range of companies, economies and stockchanges. Studying just one per economy is not enough.This is because this makes room for any anomalies in the data and collecting additionaldata will aid to determine which data is an anomaly and which aren’t when compared to arange of examples. There have been very few studies of this nature outside of the USA andso one could test a range of developing economies of which are outside of the USA. This ismainly because such data has proven to be quite difficult to obtain in the past, howeverwith the invention of the internet more information than ever is at anyone’s fingertipsproviding they have a laptop and a connection. Especially when studying the MiddleEastern economies as it is against the Muslim religion to trading in these markets as thisconstitutes a gambling and involves interest payments.However, these studies could aid regulators to better understand what exactly is going onin the markets domiciled in their countries, and because in some cultures there is a largedegree of bribery connected with the disclosing of insider trading, regulators can have abetter chance in changing the way in which the markets are facilitated and the resourcesused.BA (Hons) Business Management | University of East Anglia Page 26
  28. 28. A Comparison of Stock Market Efficiency between the US and Emerging MarketsFurthermore, it is possible that the dates which were used for the news released may nothave been the dates at which the news was actually released, and was in fact the date atwhich the press release was written, which would affect the data. The dates were taken asthe dates mentioned on the news releases themselves, however, this may be a few daysbefore and which could explain the significant returns from the reaction of the investors afew days before day (0) which would disprove that insider trading is taking place in bothMexico and the USA.Another factor which could be changed was the holding period. The holding period whichthis research used was one day. However, longer holding periods could be analysed tocompare excess returns over different holding periods.BA (Hons) Business Management | University of East Anglia Page 27
  29. 29. A Comparison of Stock Market Efficiency between the US and Emerging MarketsReferences APL event-study.avi (2011) [video] paldejong. Ausubel, L. (1990) Insider Trading in a rational expectations economy. American Eco- nomics Review, 80 p.1022-1041. Bainbridge, S. (1998) Insider Trading: an Overview. Encyclopaedia of Law and Eco- nomics, Nber. Bhattacharya, S. and Daouk, H. (2000) When an Event is not an Event: The Curious Case of an Emerging Market. Journal of Financial Economics, 55 p.69-101. Bris, A. (2005) Do Insider Trading Laws Work?. European Financial Management, 11 (3), p.267-312. Brudney, V. (1979) Insiders, outsiders, and the informational advantages under the Fed- eral Securities laws.Stanford Law Review, 35 p.322-376. Carlton, D. and Fischel, D. (1983) The Regulation of Insider Trading. Stanford Law Re- view, 35 p.322-376. Dimson, E. and Mussavain, M. (2000) Market Efficiency. The Current State of Business Displines, 3 p.959-970. Dimson, E. and Mussavain, M. (1998) A Brief History of Market Efficiency. European Financial Management, 4 (1), p.91-193. Dogu, M. et al. (2010) Empirical Testing of Insider Trading in the Istanbul Stock Ex- change. International Research Journal of Finance and Economics, (51). Dye, R. (1984) Insider Trading and Incentives. Journal of Business, 57 p.295-313. Easterbrook, F. (1985) Insider Trading as an agency problem, in JW Pratt and R.J Zeckauser, eds.. Boston: Harvard Business School Press.BA (Hons) Business Management | University of East Anglia Page 28
  30. 30. A Comparison of Stock Market Efficiency between the US and Emerging Markets Fama, E. (1970) Efficient Capital Markets: A Review of Theory and Empirical Tests. Journal of Finance, 25 p.383-417. Femsa, E. (2012) Foundations of Finance. New York: Basic Books. Finnerty, J. (1876) Insiders and market efficiency. Journal of Finance, 31 (4), p.1141-8. Fischer, P. (1992) optimal contracting and insider trading restrictions. Journal of Fi- nance, 62 p.211-35. Fishman, M. and Hagerty, H. (1995) The Mandatory Disclosure of Trades and Market Liquidity. The Review of Financial Studies, 84 (3), p.637-676. (2012) Financial Services Authority. [online] Available at: [Accessed: 15 May 2012]. Fuentes, J. and Maquieira, C. (2001) Why Borrowers Repay: Understanding High Per- formance in Chiles Financial Market, Defusing Default, Incentives and Institu- tions. Editor: Marco Pagano. Georges, S. (1976) Lutilisation en bourse dinformationprivellegieesdans le droit des Etats-Unis.Economica. Glosten, L. (1989) Insider trading, liquidity and the role of the monopolist special- ist. Journal of Business, 62 p.211-35. Guriev, G. (2003) Concentrated Ownership, Market for Corporate Control and Corpo- rate Governance. (Not Known). Moscow. Hu, J. and Noe, T. (1997) The Insider Trading Debate. Federal Reserve Bank of At- lanta, Fourth Quarter. Kahn, m. (2006) Technical Analysis Plain and Simple. Charting the Markets in Your Language. 2nd ed. New Jersey: FT Press. Kahn, M. (2006) Technical Analysis Plain and Simple. Charting the Markets in Your Language. 2nd ed. N:.BA (Hons) Business Management | University of East Anglia Page 29
  31. 31. A Comparison of Stock Market Efficiency between the US and Emerging Markets Kavussanos, M. and Visvikis, I. (2008) The lead-lad relationship between cash and stock index futures in a new market. European Financial Management, 14 (5), p.1007- 25. King, M. and Roell, S. (1988) Insider Trading. Economics, 7 p.163-193. Levine, R. (1997) Financial Development and Economic Growth: views and agenda. Journal of Economic Literature, 35 p.668-726. Lloyds Bank Review (1987) Insider Trading: Who Loses?. [press release], July 1987. Misra, M. (2011) Insider Trading: Indian perspective on prosecution of insid- ers. International Journal of Social Economics, 28 (10/11/12) p.1046-1062. Manne, H. (1966) Insider Trading and the Stock Market. New York: Free Press. Manove, M. (1989) The harm from insider trading and informed specuation. Quarterly Journal of Economics, 104 p.823-846. Maug, E. (2002) Insider trading legislation and corporate governance. European Eco- nomics Review, 46 p.1569-1597. Maug, M. (1995) Institutional investors as monitors: On the impact of insider trading legislation on large shareholders activism. (Not Known). Duke University. McGee, R. and Block, W. (1992) Insider Trading. In R.W.McGee. Westport CT: Qur- oum Books, p.219-229. Minenna, M. (n.d.) Insider Trading, Abnormal Return and Preferential Information: Su- pervising through a Probabilistic Model. Perri, F. and Brody, R. (2011) The sleeping watch dog; aka the Securities and Exchange Commission. The Journal of Financial Regulation and Compliance, 19 (3), p.1358- 1988. Reuters (2012) Mexicos Coke Femsa Reports 4th-qtr profit increase. [press release], 27 February 2010.BA (Hons) Business Management | University of East Anglia Page 30
  32. 32. A Comparison of Stock Market Efficiency between the US and Emerging Markets Stulz, S. (2005) The Limits of Financial Globalization NBER Working Paper No.W11070. (Not Known). Ohio State University. The Financial Services Authority (2008) Why Market Abuse Could Cost You Money. [online] Available at: [Accessed: 15 May 2012]. The Financial Services Authority (2010) Five charged with insider dealing. [press re- lease], 25 November 2010. The Financial Services Authority (2012) FSA fines spread bet broker £490,000 for transaction reporting failures. [press release], January 20 2011. The Securities Exchange Commission (2012) How the SEC Protects Investors, Main- tains Market Integrity, and Facilitates Capital Formation (Securities and Exchange Commission). [online] Available at: [Ac- cessed: 13 May 2012]. Unknown. (2010) ACCA Paper F9 Financial Management. 4th ed. London: BPP Lean- ing Media. Velasquez, M. (2002) Business Ethics: Concepts and cases. 5th ed. New Jersey: Pren- tice Hall. Yu, S. and Leistikow, D. (2011) Abnormal stock returns, for the event firm and its ri- vals, following the event firms large one-day stock price drop. Managerial Finance, 37 (2), p.151-172.BA (Hons) Business Management | University of East Anglia Page 31
  33. 33. A Comparison of Stock Market Efficiency between the US and Emerging MarketsAppendices (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 -0.00048 -0.02716 -0.02716 -1.22728 0.001424 0.000496 -0.02667 0.022395 0.000336 -0.00134 -0.02801 -0.06055 0.000131 0.01165 -0.01636 0.526387 0.001678 -0.00746 -0.02381 -0.33683 -0.00089 -0.00547 -0.02928 -0.24701 0.002889 -0.00389 -0.03317 -0.17594 0.000807 -0.00145 -0.03462 -0.06537 0.000517 -0.0007 -0.03532 -0.03162 0.000334 -0.01196 -0.04728 -0.54035 0.000362 0.008344 -0.03894 0.376991 0.000235 0.001969 -0.03697 0.088967 0.00029 0.022156 -0.01481 1.001065 0.000267 -0.0224 -0.03721 -1.01207 0.000931 -0.00221 -0.03942 -0.10002 0.000549 0.000919 -0.03851 0.04151 0.002684 0.003821 -0.03468 0.172635 0.00023 0.001591 -0.03309 0.071873 -0.00255 -0.01281 -0.0459 -0.57862 0.002311 -0.01911 -0.06501 -0.86322 0.000246 0.005855 -0.05915 0.264528SLOPE (M) 0.686767INTERCEPT (C) 0.002512STANDARD ERROR 0.014424BA (Hons) Business Management | University of East Anglia Page 32
  34. 34. A Comparison of Stock Market Efficiency between the US and Emerging MarketsAppendices (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 0.008087 -0.00156 -0.004 -0.10798504 0.004085 0.007573 0.003574 0.52502105 0.003071 0.003342 0.006916 0.2316697 0.007282 0.011072 0.017988 0.76761842 -0.00206 0.015186 0.033175 1.05284601 0.007623 -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 0.09678625 0.008499 -0.00769 0.006102 -0.53301124 0.010637 0.010656 0.016758 0.73875155 0.006656 -0.00079 0.015969 -0.0546546 0.001437 0.011091 0.027061 0.76893243 0.015453 0.013714 0.040774 0.95074054 0.002705 0.035106 0.07588 2.43380316 0.006045 -0.01286 0.063017 -0.89178278 0.002263 -0.00225 0.060771 -0.15570927 0.007696 0.018825 0.079596 1.30511107 0.001582 0.006503 0.086099 0.45083964 0.002774 -0.00848 0.077615 -0.58816368SLOPE (M) -0.064201866INTERCEPT (C) 0.000727636STANDARD ERROR 0.022132762BA (Hons) Business Management | University of East Anglia Page 33
  35. 35. Apple Returns vs The NASDAQ Market Average 0.04 0.03 0.02 0.01Returns Rm Ar 0 -10 -9 -8 -7 -6 -5 -4 -3 -2 -1 0 1 2 3 4 5 6 7 8 9 10 -0.01 -0.02 -0.03
  36. 36. A Comparison of Stock Market Efficiency between the US and Emerging Markets 0.06 Coca-Cola Abnormal Returns vs. Market Average 0.05 0.04 0.03 0.02 0.01 Rm Ar 0 -10 -9 -8 -7 -6 -5 -4 -3 -2 -1 0 1 2 3 4 5 6 7 8 9 10 -0.01 -0.02 -0.03 -0.04BA (Hons) Business Management | University of East Anglia Page 35