Efficiency of Price Discovery in Thinly Traded Stocks: Evidence from Dual Listings in Tel Aviv and the OTC*

Transcription

1 Efficiency of Price Discovery in Thinly Traded Socks: Evidence from Dual Lisings in Tel Aviv and he OTC* Shmuel Hauser Ben Gurion Universiy of he Negeve and Israel Securiies Auhoriy, Israel Azriel Levy Bank of Israel and he Hebrew Universiy, Israel The increasing populariy of non-dealer securiy markes ha offer auomaed, compuer-based, coninuous rading reflecs he convenional wisdom ha such markes are more efficien for all issues, large and small. This aricle uses a recen esing mehodology o esimae he relaive efficiency of discree versus coninuous rading regimes in he price discovery of hinly raded socks. The empirical ess use over 9,000 ransacions of dually lised socks raded discreely on he Tel Aviv Sock Sock Exchange and coninuously in he Over-The-Couner marke in he U.S. I is shown ha sock prices over-reac o he arrival of new informaion and noise rading in boh markes, bu more so under coninuous rading in he OTC marke. I is also shown ha coninuous rading generaes larger pricing errors and relaed reurn volailiy. These findings sugges ha a swich of hinly raded securiies from discree o coninuous rading may lower he efficiency of price discovery and raise reurn volailiy (JEL G4, G5). Keywords: coninuous rading, discree rading, pricing efficiency, Tel Aviv Sock Exchange, rading mechanism. I. Inroducion This aricle compares he efficiency of price discovery under discree and coninuous rading for small socks characerized by a low rading *We are indebed o Yakov Amihud, Yoav Friedman, Shmuel Kandel, Beni Lauerbach, and Haim Levy for useful commens, and o Peer Theodossiou and Uzi Yaari for heir invaluable help in refining our esimaion model and wriing he final draf. This research was suppored by he Krueger Fund. (Mulinaional Finance Journal, 998, vol., no., pp ) Mulinaional Finance Sociey, a nonprofi corporaion. All righs reserved.

2 34 Mulinaional Finance Journal volume. I follows in he seps of a growing number of sudies showing ha marke srucure has imporan consequences for he behavior of sock prices. The focus on small issues is moivaed by he recen rend of esablishing compuerized coninuous rading in sock markes worldwide, including emerging markes which are dominaed by small issues and low-volume rade. Mos aricles invesigae marke microsrucure effecs on he pricing of securiies by assessing marke liquidiy hrough he bid-ask spread, liquidiy raios, or reurn-variance raios., 3, 4 Grossman and Miller (988) criicize he use of he bid-ask spread and liquidiy raios as measures of marke liquidiy. They argue ha he bid-ask spread oversaes he ransacion coss of a marke maker, and liquidiy raios fail o disinguish beween ransiory price changes and permanen changes. According o Hasbrouck (993), he main drawback of variance raios is heir sensiiviy o he horizon used in heir esimaion. 5 Insead, he proposes a decomposiion of he reurn variance ino wo componens: one due o efficien pricing and he oher due o illiquidiy coss. 6 In his model, he qualiy of a rading mechanism is measured by he abiliy o faciliae efficien price discovery and enhance marke liquidiy. If a sock s pricing error is defined as he difference beween observed ransacion price and unobserved inrinsic value, smaller pricing errors reflec a beer rading mechanism. This aricle exends previous evidence on he effecs of he rading mechanism on liquidiy by esing he hypohesis advanced by Hauser, Levy, and Yaari (999) ha he efficiency of price discovery of hinly raded securiies may be greaer under discree rading han under a. For example, Garman (976), Mendelson (98), Amihud and Mendelson (987), Grossman and Miller (988), and Domwiz and Wang (994).. See Roll (984). 3. See Cooper, Groh, and Avera (985), Hasbrouck and Schwarz (988), and Tanner and Priche(99). 4. For example, George and Hwang (995). 5. Variance raios are defined as he reurn variance over a shor horizon divided by he reurn variance over a long horizon. 6. This idea can be raced o Amihud and Mendelson(987), Hauser, Tanchuma, and Yarri(998), and Yaari, Garbade, and Silber (979b) and (987), who decompose he variance in a similar manner.

3 Efficiency of Price Discovery in Thinly Traded Socks 35 coninuous rading. According o his hypohesis, an increase in he ime inerval beween rades produces wo conradicory effecs on reurn volailiy. On he one hand, he increased flow of informaion per session increases he porion of reurn volailiy caused by pricing errors; on he oher hand, he increased number of raders per session decreases he average pricing error and he resuling reurn volailiy. The daa consis of five relaively small Israeli companies whose socks are raded discreely on he Tel-Aviv Sock Exchange (TASE) and coninuously in he Over-The-Couner marke (OTC) in he U.S. Using an empirical mehod proposed by Damodaran (993), he effecs of rading frequency on pricing efficiency are esimaed by comparing across markes he porion of reurn volailiy caused by pricing errors. 7 The advanage of esing our hypohesis on dually lised socks is ha, excep for differences in he rading mechanism, he absence of arbirage opporuniies ensures he same risk and reurn characerisics in he wo markes. The findings show ha he dispersion of reurn caused by pricing errors is smaller under discree rading on he TASE han under coninuous rading in he OTC marke. They also show ha share prices over-reac o he arrival of new informaion and noise rading in boh marke, bu more so under coninuous rading in he OTC marke. These findings suppor he broad hypohesis ha differences in price volailiy across markes are a leas in par aribuable o differen rading mechanisms. They also suppor he narrow hypohesis ha discree rading a some frequency can reduce he reurn volailiy of hinly raded securiies by reducing pricing errors. The underlying heory predics ha he laer effec would be economically significan only for hinly raded securiies, so ha discree rading a some frequency can be opimal only for such securiies. 8 The remainder of he paper is organized as follows. Secion II describes he main differences beween he rading sysems of he TASE and he OTC marke. Secion III discusses he mehodology of esing he relaive efficiency of price discovery in he wo markes. The 7. See Mendelson (98), Choen and Schwarz (989), Forser and George (99), and Mandhaven (99). 8. See Hauser, Levy, and Yaari (999) and a recen sudy by Amihud, Mendelson, and Lauerbach (997).

4 36 Mulinaional Finance Journal empirical findings are repored in secion IV followed by conclusions in secion V. II. The Trading Mechanisms Three differences in he funcioning of he TASE and he OTC marke are relaed o wo insiuional dissimilariies: The TASE is a non-dealer marke wih discree rading; he OTC is a dealer marke wih coninuous rading. Firs, all orders on he TASE are accumulaed and execued ogeher; buyers and sellers in he OTC marke coninuously inerac, direcly or hrough dealers. Second, he TASE is an aucion marke; rading in he OTC is conduced hrough a compuerized nework of he Naional Associaion of Securiies Dealers Auomaed Quoe Sysem (NASDAQ), for he mos par a dealer marke where invesors are faced wih price quoes. Based on hose quoes, invesors place heir orders wih brokers who buy and sell for heir own accoun or execue orders wih oher dealers. 9 Third, he TASE operaes in he absence of bid-ask quoes; invesors in he OTC marke place heir orders based on bid-ask quoes and he execuion of orders usually occurs beween he bid and ask prices. In furher explanaion of he hird difference beween he wo markes, i should be noed ha during he sampling period here were wo differen rading mehods on he TASE. 0 The firs mehod is a compuerized call marke for he leas liquid socks. I serves as a fully auomaed bach marke designed o mimic he preceding aucion session in which paricipans on he rading floor reac o he difference beween aggregaed orders o buy (demand) and sell (supply) subjec o price limis. The second mehod, designed for he 00 mos liquid socks, is based on bilaeral semi-coninuous rading. The rading day begins wih an opening session of a call marke similar o he compuerized call sysem. This session, designed for he execuion of small orders, informs raders abou he marke rend. The opening 9. See Blume and Siegel (99). 0. See Bronfeld (994).. Noice ha he opening price is se only owards he end of he firs round in he main session. A he ime rading in he main session begins, he price of he opening session is no

5 Efficiency of Price Discovery in Thinly Traded Socks 37 session is followed by he main aucion session consising of a few rounds in which he 00 socks are raded in hree separae groups, in separae rooms. In each round, rading in each room begins wih he aucioneer s announcemen of he sock raded firs, followed by announcemens by ineresed buyers and sellers of he opening bid and ask prices. Price gaps are closed by negoiaion which is open o oher exchange members. A price agreemen resuls in ransacions followed by an announcemen of he nex sock o be raded a process which is repeaed unil all socks have been raded. The firs round is followed by he aucioneer s announcemen of he second round, ec. Trading, which ends a 4:00 PM, averaged six rounds per sock per day during he sampling period. III. Mehodology The empirical model developed below is designed o compare he efficiency of price discovery under he wo rading mechanisms. I is based on a heoreical price adjusmen model of Amihud and Mendelson (987). I is followed by a descripion of relaed empirical model proposed by Damodaran (993). A. Noise Trading and Adjusmen o New Informaion Amihud and Mendelson (987) specify he securiy price by P = γv + ( γ ) P + u, () where P is he observed price and V he unobserved inrinsic value a ime, boh expressed in naural logarihms; is he price-adjusmen coefficien, and u is a zero-mean random error wih a variance σ u Equaion posulaes ha he observed price a ime is a weighed known. The only informaion available a ha poin is abou he excess of supply or demand for shares. In oher words, here is no opening price on he TASE similar o ha in he OTC.. For some of he finer poins in his subsecion, we are indebed o he managing edior Peer Theodossiou.

6 38 Mulinaional Finance Journal average of he inrinsic value a ha ime and he observed price a. The coefficien measures he speed of price adjusmen owards he inrinsic value. The value = implies insananeous (full) adjusmen, so ha P = V + u. The value = 0 implies no price adjusmen oward he changing inrinsic value, so ha P = P + u, where he price logarihm follows a pure random walk process. The inrinsic value is specified as a random walk process wih a drif V = m+ V + e, () where he drif, m, is measured as coninuously-compounded periodic reurn, and e is a zero-mean random error wih a variance σ e. Noe ha m = E(V V ) represens he expeced growh rae of V. I follows from () and () ha 0 5 V P = ( γ ) m+ ( γ ) V P + ( γ ) e u and afer recursive subsiuion V P = ( ) m ( ) + ( ) V P s γ γ γ s= s + ( γ) ( γ) e s+ u s= 0 5 ( ) γ = ( γ ) m ( γ ) V0 P0 γ (3)

7 Efficiency of Price Discovery in Thinly Traded Socks s + ( γ) ( γ) e s+ u s= The assumpions and 0< < imply lim( γ ) = 0, allowing simplificaion of he las equaion o s V P = ( γ) m+ ( γ ) ( γ) e u s= 0 s+ + s 5. (4) Wih he addiional assumpion variance of (4) are lim( γ ) = 0, he expecaion and and 0 5 γ EV P = m γ s var( V P) = ( ) ( γ ) var ( γ) e u s= 0 s+ s+ 5 ( γ ) 7 = ( γ) σ + e σ u ( γ ) 7 (5) (6) ( γ ) = ( γ ) σ e + ( γ ) σ. u Equaion 5 shows ha under a slow marke adjusmen o new informaion, indicaed by a coefficien in he inerval 0 < <, he securiy price will sysemaically undersae he inrinsic value, P < V. Insananuous adjusmen, indicaed by =, will cause P = V. Marke overreacion, indicaed by < <, will lead o sysemaic overpricing, P > V. Based on equaions and, he rae of reurn, R, is defined by R P P = V P + u γ 0 5

8 = γ V P + γ m+ γ e + u. Mulinaional Finance Journal Subsiuion of (4) in he righ-hand side of he las expression yields s R = ( γ) m+ γ ( γ ) ( γ) e u + γ m+ γ e + u s= 0 s+ s+ 5 0 s+ s+ 5 s = γ ( γ) ( γ) e u + γ e + u s= s + m+ γ ( γ) e u + u. s= 0 5 s+ (7) Based on (7), he reurn mean and variance are and E0R5= m, (8) γ ( γ) γ var0r 5 σ r = σ e + σ u + γ σ e + σ u ( γ ) ( γ ) γ γ = σ + σ ( γ ) e ( γ ) u (9) γ = +. γ σ γ σ e u Equaions 7, 8, and 9 provide he basis for comparing he pricing efficiency of each of he five hinly raded socks under discree and coninuous rading. Damodaran s empirical model described below is used o esimae he parameers of (9);, σ e, and σ u. B. Damodaran s Model Damodaran (993) provides a mehod for esimaing he price adjusmen coefficien in he Amihud-Mendelson model. This parameer, which quanifies he exen of adjusmen of ransacion

9 Efficiency of Price Discovery in Thinly Traded Socks 4 prices owards he securiy s inrinsic value, is used in esimaing he porion of reurn variance caused by price adjusmen. This porion of he variance is aribued o informaion-uncorrelaed pricing errors caused by noise rading and illiquidiy. This model decomposes he variance of R according o σ = σ + σ + γ σ γ + σ, (0) γ r e u e u where he las wo erms represen he reurn volailiy caused by price adjusmen. When, clearly is a biased esimaor of he dollar γ σ r reurn variance, σ e. Full price adjusmen is represened by =, a case in which σ r = σ e +σ u. Following equaions 7-0, Damodaran derives a measure of based on hree assumpions: 3 () V is i.i.d and follows a random walk; () he noise erms and inrinsic value processes are independen; and (3) he price-adjusmen coefficien approaches uniy as he rading inerval is exended. Under hese assumpions, he variance of reurns over a rading inerval j is var Rj, 6=! γ j γ j jσ e + γ σ u j " $ #, () where j is he price adjusmen coefficien for j-inerval reurns. Assuming j =,,..., k, where k is a sufficien rading inerval allowing =, Damodaran shows ha var R j, 6 6 var Rk, = σ e k! where he noise erm variance is γ " $ # " +! j k$ # γ = cov R,, R, 6, 6,, 6 j σ u γ j σ u k k, () and he inrinsic value variance is σ e = var R k + cov R k, R k k. Subsiuion of (), σ e and σ u ino () yields Damodaran s esimaed 3. See discussion in Damodaran (993), p. 389.

10 4 Mulinaional Finance Journal j for any rading inerval j var r j+ cov r, r j j, k k, γ j = var j, 6 + var k, 6 + cov k,, k, 6 r j r k r r k. (3) In esimaing j from (3), we follow Damodaran by assuming k = 5 days. 5 IV. Tes Resuls A. Daa Of he five dually lised socks examined in his paper, four (Teva, Elbi, Elron, and Ary) were raded on he TASE in he semi-coninuous sysem, and one (Roboec) was raded once a day. Sricly speaking, boh rading mehods are discree. Alhough during he sampling period here were close o sixy Israeli companies lised in he U.S., only seven of hem were dually lised. Incomplee daa for wo of he companies reduce he sample o five socks. The sampling period sars in July 988 o avoid he effec of he Ocober 987 marke crash in he U.S. (see Malliaris and Urraia (993)), and ends in Sepember 993, six monhs before he Israeli marke crash. In February 994 sock prices on he TASE dropped by an average of 40 percen. The decision no o exend he sample beyond 993 was furher promped by a 994 policy change of he Bank of Israel ha increased he exchange rae volailiy by relaxing he foreign exchange conrol (more on his below). Any damage caused by ending he sampling period in Sepember 993 is likely o be small in view of our finding ha differen sub-periods beween July 988 and Sepember 993 generae similar resuls. The decision no o exend he sample beyond 993 was furher influenced by daa problems saring in 994 for wo of he companies. An 4. This formula is Brisley and Theobald s (996) correcion o he one suggesed by Damodaran (993). 5. For a deailed discussion and empirical resuls concerning he choice of, see Damodaran (993).

11 Efficiency of Price Discovery in Thinly Traded Socks 43 ownership change in Ary caused a subsanial increase in rading volume, and problems in compiling Roboec s sock prices damaged he qualiy of is daa. Our daa consis of over 9,000 daily closing share prices and rading volume for he five socks in boh markes and daily closing figures of he S&P 500 and he TASE general sock index. Raes of reurn (log reurns) of he five socks were adjused for dividends and splis. Three daa-relaed issues deserve furher consideraion. The firs issue concerns he shekel denominaion of sock prices on he TASE. Those prices were convered o U.S. dollars a he relevan exchange rae so ha dollar raes of reurn on he TASE include raes of reurn in Israeli currency plus he change in he exchange rae. The poenial difficulies creaed by relying on a represenaive exchange rae concern is synchronizaion wih closing sock prices and is relevance as a marke price. These poenial difficulies do no appear o inerfere wih our resuls because he same rae was used by all Israeli banks and in mos foreign exchange ransacions hroughou he day. 6 Moreover, mos invesors in he socks sudied were Israelis who could legally buy and sell foreign currency only in Israeli banks and herefore only a he same rae. The insignificance of hese facors is furher suggesed by evidence ha he correlaion coefficien beween sock reurns and percenage changes of he exchange rae was close o zero, and he daily volailiy of he exchange rae was less han 3% of he daily volailiy of share prices. To furher examine he effec of his issue on our resuls, we recalculaed he resuls using alernaively he spo exchange rae of he previous and following days o find only negligible effec on he resuls. The second issue concerns he ime difference beween he wo markes, since rading in New York begins approximaely when rading in Tel Aviv ends. The risk and reurn parameers are no affeced by he ime difference since hey are esimaed separaely in each marke. This allows us o circumven he problem raised by Kahya (997), who argues ha conemporaneous correlaion measures mus be adjused for 6. This pracice was recenly changed. During he sampling period he exchange raes was, o a large exen, deermined by he Bank of Israel which daily sold and bough foreign reserves equal o he marke excess demand or supply. The represenaive exchange rae se a noon was he one ha cleared he marke beween he commercial banks and he cenral bank.

12 TABLE. Derscripive Saisics of he Five Dually Lised Socks 44 Daily Volume Average of Log Reurns % Sample of Trade Share Log Sandard Firm Marke Period Million $ Price $ Spread % Mean Deviaion Skewness Kurosis Teva OTC 7/88-9/ TASE (.38) (00.9) Elbi OTC 7/88-9/ TASE (.55) (9.3) Elron OTC 7/88-9/ TASE (.03) (8.9) Roboec OTC 8/9-/ TASE (.0) (7.7) Ary OTC 8/9-/ TASE (.0) (07.7) NIS/$ 7/88-/ Noe: The log-spread represens he average percenage difference beween he bid and ask quoes based on end-of-he-monh figures repored by Bloomberg. All figures are calculaed over he enire sampling period. For all five socks, he null hypohesis of equal mean reurns across markes canno be rejeced using a wo-sample -es (numbers in parenhesis are -values). The sandard deviaion of reurns indicaes rejecion of he null hypohesis of equal volailiy across markes using Piman s es for dependen samples (numbers in parenhesis are F-values). NIS/$ is he represenaive New Israeli Shekel agains he U.S. dollar. Mulinaional Finance Journal

13 Efficiency of Price Discovery in Thinly Traded Socks 45 non-overlapping rading hours of sock markes. This issue is furher examined below. The hird issue concerns he use of closing prices raher han inraday ransacion prices. Garbade and Silber (979a) and Hauser, Levy, and Yaari (999) demonsrae ha disurbances do no accumulae over he observaion period. This finding allows us o gauge he pricing error variance of consecuive ransacions from closing prices. Noe ha our empirical analysis is limied o close-o-close reurns since he daa do no allow us o break he analysis ino open and close periods. Separaing he analysis ino open and close reurns has he advanage ha hey do no overlap in ime as do close-o-close reurns (see Amihud and Mendelson (987)). However, as poined ou above, open share prices did no exis on he TASE. B. Desripive Saisics: Volume, Spread, Mean Reurn, and Volailiy This secion provides descripive saisics of he daa. Figures displayed in able show significan differences in he volume of rade beween he wo markes and among he securiies in each. This is refleced in he large bid-ask spread ha characerizes our hinly raded socks. Excep for Teva and Roboec, he average daily rading volume is higher in he TASE han in he OTC. However, even in hese wo socks, he rading volume per ransacion is higher on he TASE due o a smaller number of ransacions. This poin is furher discussed below. In addiion, we compued he average rae of reurn and sandard deviaion. As expeced, he resuls displayed in able indicae ha he annual mean raes of reurn in he wo markes are no significanly differen. Ye, he sandard deviaions are significanly differen. Having discarded he possibiliy ha significan differences in reurn volailiy were caused by exchange rae volailiy (see Secion 4.A), he aricle proceeds o examine he impac of differences in he rading mehods. C. Damodaran s Model Informaion-uncorrelaed pricing errors are hose likely o resul from price discreeness, ransien liquidiy effecs, invenory conrol effecs, and noise rading (Hasbrouck [993], p.97). Table repors esimaes of he speed of price adjusmen o arriving new informaion and is

14 46 Mulinaional Finance Journal TABLE. Informaion-Uncorrelaed Pricing Errors: Damodaran s Mehod Price Adjusmen Price Adjusmen Effec Firm Marke Coefficien, on Reurn Volailiy Teva OTC TASE Elbi OTC TASE Elron OTC TASE Roboec OTC TASE Ary OTC TASE..3 Kruskal Wallis Saisic P-value Noe: The relaive qualiy of a rading mechanism is esed by comparing price adjusmen o new informaion in he wo markes. The mehodology relies on he Amihud- Mendelson model for he difference beween a securiy s inrinsic value and observed price, where is he price adjusmen coefficien (0< <) and u is a noise erm. The value = indicaes full price adjusmen o new informaion, and price over-reacion o new informaion. Parameer is esimaed based on Damodaran s mehod decomposing he variance of r ino four componens: γ σ r = σ e + σ u + σ e σ u, γ γ + where he las wo represen he price adjusmen effec on reurn volailiy. If he rading ime inerval,, is sufficien o allow =, he price adjusmen coefficien j for any inerval j is var r, j + cov r, r, j =, var r j + var r k + cov r, r k j k k γ j j, k, k, k, where j =,,...,, and r j, and r k, are he reurns for rading inerval j and, respecively. Following Damodaran, we assume k = 5 days in esimaing j. Coefficien is he one-day speed of adjusmen. Kruskal-Wallis saisics are based on he Kruskal-Wallis non-parameric es for cross-secional comparison of medians. effec on reurn volailiy based on Amihud and Mendelson (987) and Damodaran s (993) model for esimaing he speed of adjusmen. In all cases, prices adjus faser on he TASE han in he OTC marke, consisen wih he hypohesis ha discree rading on he TASE leads

15 Efficiency of Price Discovery in Thinly Traded Socks 47 o greaer pricing efficiency. 7 Above-one coefficiens of price adjusmen averaging.68 in he OTC marke and.073 on he TASE sugges ha in boh markes sock prices end o over-reac o arriving new informaion, bu more so under coninuous rading. Like Damodaran, we recognize ha his esimaion procedure does no include significance ess (see Damodaran (993) p. 393). Therefore, following Damodaran, we added a non-parameric es (Kruskal Wallis) for cross secional comparison of medians. The resuls indicae, again, ha sock prices end o over-reac o arriving new informaion, and more so under coninuous rading a he 4.7% significance level. Consisenly, he reurn volailiy aribued o price adjusmen he sum of he las wo erms in equaion 0 is greaer in he OTC marke for all five securiies (see column 4 in able ) a he.6% significnace level. These resuls unambiguously confirm he hypohesis ha hinly raded securiies may be more efficienly priced under discree rading han under coninuous rading. V. Summary and Conclusions This paper exends previous evidence on he effecs of he rading mechanism on marke liquidiy, focusing on he efficiency of price discovery of small issues under discree versus coninuous rading. The exensive sudy of a small number of hinly-raded socks dually lised on he TASE and he OTC shows ha hose socks are more efficienly raded a discree ime inervals on he TASE han coninuously in he OTC marke. A comparison of he wo markes shows ha, for each of he socks sudied, he porion of reurn volailiy aribued o pricing errors is significanly greaer under coninuous rading in he OTC marke. I also shows ha sock prices overreac o new informaion and noise rading in boh markes, bu more so under coninuous rading in he OTC marke. These findings suppor he broad hypohesis ha differences in reurn volailiy across markes are, a leas in par, aribuable o he use of differen rading mechanisms. They also suppor he narrow hypohesis ha discree rading a some frequency can reduce he reurn volailiy of hinly raded securiies. 7. An alernaive explanaion for he faser price adjusmen on he TASE is he dominan role played by he home marke where much of he informaion is released. See Chowdhry and Nanda (99) and Hauser, Levy, and Yaari (999).

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