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1 ASIAN JOURNAL OF MANAGEMENT RESEARCH Online Open Access publishing plaform for Managemen Research Copyrigh 2010 All righs reserved Inegraed Publishing associaion Case Sudy ISSN Global Financial Crisis: Chinese Sock Marke Efficiency Faiq Mahmood, Xia Xinping, Humera Shahid, Muhammad Usman School of Managemen, Huazhong Universiy of Science and Technology, Wuhan, China ABSTRACT This sudy endeavors o examine he efficiency of Chinese sock marke and how he global financial crisis influences he efficiency of Chinese sock marke. In order o deermine he efficiency of Chinese sock marke we apply efficien marke hypohesis of random walk and divide our daa sample ino wo periods: one is before global financial crisis and oher one is during crisis. Here we apply ADF, DF GLS, PP and KPSS ess on sock marke reurns in order o check he uni roo in daa series for boh Shenzhen and Shanghai sock exchanges separaely. The resuls of he sudy shows ha Chinese sock marke is weak form efficien and pas daa of sock marke movemens may no be very useable in order o make excess reurns and he global financial crisis has no significan impac on he efficiency of Chinese sock marke. 1. Inroducion The erm marke efficiency is broadly used in capial markes o explain he degree o which he presen asse price or sock price reflecs all available informaion in he marke place and hus relying upon his informaion one can buy or sell he socks which should, on average reurn invesors only a fair measure of reurn afer deducing ransacion coss for he associaed risk. Samuelson (1965) provides he concep of efficien marke hypohesis (EMH) according o which he prices of an asse flucuae randomly and furher his concep is revised by Fama (1970,1991) in which he evidenced for marke efficiency on he basis of developmen in research. For making invesmen policies boh in emerging and developed markes, he concep of marke efficiency has imporan implicaions. Differen invesmen sraegies could be adoped afer deciding wheher he marke is efficien or inefficien. For example, in an efficien marke he bes sraegy o make opimal profi is o concenrae on risk and reurn feaure of an asse or porfolio, because when he marke is efficien he price of an asse reflec he marke, so he bes way o esimae he risk and expeced reurn of he asse, aking ino accoun wha is known abou he asse a ha ime. Therefore, in such case here will be no undervalued asses offering higher han expeced reurn or overvalued asses offering lower han he expeced reurn. In conras, if he marke is no efficien he bes way o make invesmen is o spo winners and losers in he marke and correc idenificaion of miss priced asses could help o enhance or opimize he performance of overall invesmen (Ruerford; 1993). The facor of globalizaion and rapid growh in echnology innovaion enhance inegraion of financial markes world over, so he undersanding of marke efficiency even in emerging markes is becoming more imporan as a consequence of inegraion wih more developed markes and free movemen of invesmens across naional boundaries. In developing counries like China, he conribuion of equiy ASIAN JOURNAL OF MANAGEMENT RESEARCH 90

2 markes in he process of developmen is less as compare o developed markes and he equiy markes of wesern developed world considered more efficien han developing naions. Due o facor of inegraion and reform process o open economies in emerging markes provide chances of geing heavy capial inflows from developed markes o developing markes and make his possible for invesor o diversify heir invesmens and risks across boundaries. China is one of he fases growing emerging economies in he world and rapidly growing from las 30 years since is opening in The wo sock exchanges in Shanghai and Shenzhen were esablished in early 1990s and differen reform process were iniiaed as a resul demand for invesmen funds sill growing significanly and capial marke growh expeced o play an increasingly imporan role in he process of developmen. A his ransiional sage o developmen, i is very imporan o access he level of efficiency of he Chinese equiy marke in order o esablish is long erm role in he process of economic developmen. The purpose of his sudy is o es wheher Chinese sock marke is weak form efficien or no in normal circumsances and wha impac global financial crisis has on he efficiency of Chinese sock marke. Under Efficien Marke Hypohesis (EMH) o predic fuure expeced prices or reurns, we could use pas acual prices or reurns. The behavior of share price changes could esed for serial independence and random walk heory for equiies prices show an equiies marke in which new informaion is quickly discouned ino prices and abnormal or excess reurns canno be made from observing pas prices. In order o idenify principle process and behavior of marke reurn generaion he paern of shor erm movemens of combined marke reurn is he key hrough which we could measure he hisorical marke efficiency. The concep of marke efficiency based on he heory of random walk process hrough which we deermine underlying marke is efficien or inefficien. If he marke is efficien hen i follows a random walk process and model will fail o idenify any paern, in such case hisorical daa canno be useful o deermine expeced reurns. On oher hand if marke is no efficien hen i means marke is no following a random walk process and he model used will idenify he paern of marke movemen, in his case daa series is considered o be saionary and hisorical daa can be useful o idenify fuure reurns. Here from above discussion i is clear ha idenificaion of paern in ime series daa is he main key o deermine ha marke is efficien or inefficien. Eugene Fama (1970) idenified hree levels of marke efficiency: Weak form efficiency: The marke said o be weak form efficien when prices of he securiies insanly and fully reflec all informaion of he pas prices, so he fuure price movemens canno be prediced by using pas prices. Semi srong efficiency: In such case, he prices of securiies or asses fully reflec all he publicly available informaion. Therefore, only invesors wih addiional inside informaion could have advanage in he marke. Srong form efficiency: In his caegory, he prices of securiies fully reflec all he publicly available informaion along wih privae informaion (inside informaion). Therefore, in such a case, no one can have advanage in predicing reurns in he marke, because here is no daa ha would provide addiional value o he invesors. ASIAN JOURNAL OF MANAGEMENT RESEARCH 91

3 2. Lieraure Review The essence of efficien marke heory was aken from he concep of random walk heory. Bachelier in 1900 inroduces he idea ha asse prices may follow a random walk paern. The fuure pah of he price level of a securiy is no more predicable han he pah of a series of accumulaed random numbers or in saisical erms successive price changes are independen and idenically disribued random variables Fama(1965). In conras o his heory Andrew W. Lo (1988) oally rejec he heory of random walk by aking he daa ino sample period from and concluded ha he pas prices daa canno be aribue compleely o he effecs of infrequen rading or ime varying volailiies. In following o hese earlier sudies some oher researchers conduc same random walk concep hypohesis o es is implicaion on financial daa of differen counries markes which can be grouped ino developed and emerging markes e.c. Korea (Ryoo and Smih (2002) use a variance raio es and find ha he marke follow random walk paern, if he price limis are relaxed. China, (lee e al 2001) uses GRAPH and EGRAPH models and found ha he volailiy is highly persisen and predicable. Hong Kong (Cheung and Cous 2001) by using variance raio es found ha he index on Hong Kong sock marke follow a random walk. Spain (Regulez and Zarraga, 2002), Africa (Smih e al. 2002; Appiah kusi and Menyah, 2003), and Middle Eas (Abraham e al. 2002) hey all use variance raio ess and runs es on he financial daa of differen counries for esing random walk hypohesis and found week form efficien hese markes are and follow a random walk. The concep of efficien marke hypohesis was firsly inroduced by Samuelson (1965) ha properly anicipaed price of an asse flucuae randomly. Fama (1970) presened a formal review of heory and evidence for marke efficiency. To prove he heory in his empirical work he divided securiy prices ino hree informaion subses firs one was week form es, second is semi srong form es and hird one was srong form es. He characerized an efficien capial marke in which securiy prices fully reflec all available informaion and furher revised his heory on he basis developmen research in 1991.In his revised work he hypohesize on informaion and rading coss, he coss of geing prices o reflec informaion (Fama 1991). Upon he connecion informaion and marke efficiency Bernard and Thomas (1990) presen a robus esing model in which hey conclude ha prices may parially reflec he informaion regarding fuure earnings, bu no reflec all available informaion by focusing on abnormal reurns a he ime of earnings announcemens, and also argue ha hese can be prediced from he unexploied informaion in pas earnings. They also demonsrae ha he signs of average abnormal reurns a quarerly earnings announcemen daes agree wih hose prediced by a model ha explois he (+,+,+, ) signs of he serial correlaion. Buron G. Malkiel (2003) examines he aacks on he efficien marke hypohesis and believe ha he sock prices are parially predicable by focusing on saisical findings of relaionship beween predicabiliy and efficiency, crash of 1987 and inerne bubble, he conclude ha our sock markes are far more efficien and far less predicable. In his poin of view an efficien marke do no allow invesors o earn above average reurns wihou acceping above average risks and spors he view ha sock marke has no memory and he way pas prices changed canno be use in divining how i will behave in fuure, same survey and empirical resuls were concluded in he sudy of cooner (1964). Balvers e al(1990) argue on predicabiliy of reurns, ineremporal asse pricing, and macroeconomic flucuaions by using a simple equilibrium model wih relaion o consumpion opporuniies and oupu. Consumpion opporuniies vary along wih variaions in aggregae oupu, invesors are forced wih a less smooh consumpion paern. Invesors adjus heir ASIAN JOURNAL OF MANAGEMENT RESEARCH 92

4 required rae of reurn on sock in order o smooh consumpion. This linkage provides a base in which reurns could be predicable up o an exan relaed o he predicabiliy of aggregae oupu. The change in uiliy consumpions furher resul in uiliy increasing ineremporal ransacions, so under his scenario we could say ha predicabiliy is consisen wih efficien markes. Rendleman, Jones and Laané (1987) hypohesize ha he invesors are no fully aware abou he serial correlaion in earnings which prevail among quarerly earnings changes, so hey do no use his informaion o enhance heir earnings. Efficien marke hypohesis has a wofold funcions firsly i could be use as a heoreical and predicive model for operaions in a financial marke and secondly i could be use as a echnique in impression managemen campaign o arac more peoples for invesmen in sock marke (Will 2006). Tradiionally more developed wesern equiy marke are considered o be more efficien and he conribuion of equiy markes in he process of developmen in developing counries is less due o resricions and conrols which resuled in a weak markes (Gupa, 2006) Along wih empirical lieraure on efficien marke hypohesis, many oher researchers ry o explain i hrough behavioral perspecive. Rober J. Shiller (2001) ries o explain efficien marke hypohesis hrough behavioral principles. According o shiller behavioral principles are derived from psychology, sociology and anhropology. In his work, he discussed some behavioral principles, which are relevan in conex of efficien marke hypohesis. The principles discussed are prospec heory, regre and cogniive dissonance, anchoring, menal comparmens, overconfidence, over and underreacion, represenaiveness heurisic, he disjuncion effec, gambling behavior and speculaion, perceived irrelevance of hisory, magical hinking, quasimagical hinking, aenion anomalies, he availabiliy heurisic, culure and social conagion, and global culure. Joseph E. Finnery (1974) on he opic of insider s access o informaion and marke efficiency conclude ha marke is no srong form efficien and insiders are able o ouperform he marke because hey can idenify profiable as well as unprofiable siuaions wihin heir corporaions. 3. Daa and Mehodology Number of echniques can be used o idenify paern in a series of daa and all have heir own meris and demeris. In order o measure he sock marke efficiency, his sudy will use he sock marke reurn of Shanghai and Shenzhen sock exchanges. Differen sudies have used differen mehods o measure he sock marke efficiency. Ec: 3.1 Runs Tes (Bradley 1968) I s a non parameric saisical es hrough which we could check randomness hypohesis for a wo valued daa sequence. Through run es we find ha he underlying series of daa is of increasing values or decreasing values. The number of increasing or decreasing values considered as he lengh of he run. The probabiliy ha he (I+1)h value is larger or smaller han he Ih value follows a binomial disribuion, which forms he basis of he runs es. As i s a nonparameric es so no require he reurns o be normally disribued. The null hypohesis could deermine by he same sign in price changes as i observes he sequence of successive price changes wih he same sign. The main drawback of using run es ha i could no deec he amoun of change from mean because i only looks a he number of posiive or negaive changes. ASIAN JOURNAL OF MANAGEMENT RESEARCH 93

5 3.2 LOMAC variance raio es Lo and MacKinlay (1988) proposed a es for checking he randomness of hypohesis for a value daa sequence, along wih oher criicism he main flaw in using his es is he selecion of maximum order of a serial correlaion(faus,1992). 3.3 Durbin Wason es (1951) Durbin and Wason is one among he serial correlaion ess used for finding marke efficiency in previous sudies. This es is only for firs order auocorrelaion, because i could only deec he relaionship beween an error and is immediaely preceding value. The bes way o use his es is o regress he error of ime wih is previous value. u ρ u + v = 1 2 where v ~ N ( 0, σ v ) Anoher major drawback of using DW es is ha, i could no deec residual correlaions for u, 1 = bu corr ( u, 2 ) 0 in such case he DW es will no find he example if corr ( ) 0 u u auocorrelaion. Here are some ways o remove he auocorrelaion. One possible way is o remove he error from all possible combinaions one by one, bu i s a hecic job and pracically no possible o do his lenghy exercise. The second and bes alernaive is o use a es for auocorrelaion in a form of equaion, in which relaionship beween u and several of is lagged values a he same ime could be checked. Breusch Godfrey es is among he ess widely used ' for esing auocorrelaion of he lags up o r h order u ρ u + ρ u + ρ u ρ u + v = r r 2 v ~ N ( 0, σ v Afer considering he above menioned weakness of differen models his sudy will use Augmened Dickey Fuller es (ADF es) o deec he paern in ime series daa. 3.4 Augmened Dickey Fuller es (ADF es) From he above menioned weaknesses of models, Augmened dickey fuller (1979) es is used in his sudy because i is widely used and bes fis for measuring marke efficiency (Chan 1997, Brooks 2002). This es do no follows he convenional disribuion. This es can be used o derive asympoic resuls and could simulae criical values for various ess and sample sizes. I es has muliple choices for is use. I can be used wih a consans, a linear ime rend and wih regression. For our sudy we will use he regression model in is sandard form, wih drif and wih drif and rend for esing uni roo. SPI = α SPI 1 + ε (1) SPI * * = u + α SPI 1 + ε (2) ** ** ** = u + β ( T ) + α SPI 1 ε (3) SPI The denominaion of hese equaions is as follows. Equaion (1) is for sandard model, (2) is for sandard model wih drif, (3) for sandard model wih drif and rend. SPI is he logarihm of sock price index a ime. * u and ** u are drif parameers. T is he oal number of ASIAN JOURNAL OF MANAGEMENT RESEARCH 94

6 * * observaions. ε, ε, ε *, are error erms ha could be auoregressive moving average process wih ime dependen variance. U is an arbirary drif parameer, α is he change in index and is a random disurbance erm. For checking he non saionariy of he daa he Augmened Dickey Fuller uni roo will be applied in he form of following regression equaion in order o check he null hypohesis. y θ y + u = 1 If he series will be saionary hen θ =1, and agains his, if model deec non saionariy in daa series hen θ < 1. So he hypoheses of our sudy are H 0 : Time series is saionary. H : Time series is non saionary. 1 The null hypohesis of he sudy will be rejeced if he saisical value is lesser han he criical value and daa series will be considered as non saionary (following he random walk). In his sudy we will calculae daily marke reurn by using daily marke reurns wih he help of following formula for boh Shanghai and Shenzhen sock exchanges. I R = Log ( 4 ) I 1 This sudy divide sample period ino wo groups based on crisis period. Firs one is he period before global financial crisis sared from January 1 ST 2004 o 30 TH June The second group relaes o he period of global financial crisis, sared from July 1 ST 2007 and ending on December 31 ST In order o check he saionariy of daa, daily sock marke reurns are calculaed for boh Shanghai and Shenzhen sock exchanges separaely for boh periods. The daily sock marke reurns are calculaed by applying he formula indicaed in equaion (4) upon daily sock marke index. The sample daa is colleced from CCER (Chinese cenre for economic research) daabase. Saurday and Sunday are he weekend days in china, so boh sock exchanges remain close on hese days. According o basic ime series requiremen he observaions should be aken a a regular space inerval. The requiremen however, is ha he frequency be spaced in erms of he processes underlying he series. The underlying process of he series in his case is rading of socks and generaion of sock exchange index based on he sock rading, as such for his sudy he index values a he end of each business day is appropriae (French 1980). For robus esing we use DF GLS, PP and KPSS ess. The daa characerisics are menioned in able1a and 1B and he figures below menioned depicing he behavior of daily sock marke reurns before and during he crisis, which is separaed by a red line. In order o check he saionariy of daa series, sudy uses Augmened Dicky Fuller (ADF) Tes in is sandard form wih drif and wih drif and rend for boh periods of ime separaely and for he sack of robus esing Dicky fuller GLS (DF GLS), Phillips Perron (PP) and Kwiakowski Phillips Schmid Shin (KPSS) ess are used. ε ASIAN JOURNAL OF MANAGEMENT RESEARCH 95

7 Table 1A: Daa Characerisics SHZ and SHN January 2004 June 2007 (Before Crisis) Index Obser. Mean Median Minimum Maximum Skewness Kurosis Variance SHZ SHN Table 1B: Daa Characerisics SHZ and SHN July 2007 December 2009 (During Crisis) Index Obser. Mean Median Minimum Maximum Skewness Kurosis Variance SHZ SHN Figure 1: Shanghai sock marke reurn daa series Figure 2: Shenzhen sock marke reurn daa series ASIAN JOURNAL OF MANAGEMENT RESEARCH 96

8 4. Resuls and Findings 4.1 Before Crisis Efficiency Tess Table 2 repors ha before he global financial crisis he saisical value of ADF es (wih inercep) in Shenzhen sock exchange is , which is less han is criical values of , , a 1%, 5%, and 10% respecively. Therefore, sudy rejecs he null hypohesis and concludes ha daa series is non saionary and following he random walk. The saisical values of DF GLS, PP and KPSS are also lesser han heir corresponding criical values and rejecing he null hypohesis of saionariy. The es saisics of Shanghai sock exchange for all ADF, DF GLS, PP, KPSS are also lesser han heir criical values and acceping he alernaive hypohesis of non saionariy. Only he es saisics of KPSS are greaer han criical values a 5% and 10% level of significance showing ha here is somehow saionariy in daa series. Index ADF es Saisics Wih 5 lags Table 2 (A): Tes saisics wih inercep and no rend DF GLS es Saisics Wih 5 lags PP uni roo es (Newey Wes Bandwih) SHZ SHN Table 2 (B): Criical values KPSS (Newey Wes Bandwih) Level ADF Tes DF GLS Tes PP uni roo es KPSS Tes 1% % % The ADF es saisic (wih inercep and rend) in able 3 is also lesser han he criical values in boh Shenzhen and Shanghai sock exchange. So again he null hypohesis is rejeced, concluding ha he daa series has uni roo. Same saisical conclusion is observed for DF GLS, PP and KPSS ess here. Index ADF es Saisics Wih 5 lags Table 3 (A): Tes saisics wih inercep and rend DF GLS es Saisics Wih 5 lags PP uni roo es (Newey Wes Bandwih) SHZ SHN KPSS (Newey Wes Bandwih) ASIAN JOURNAL OF MANAGEMENT RESEARCH 97

9 Table 3 (B): Criical values Level ADF Tes DF GLS Tes PP uni roo es KPSS Tes 1% % % During Crisis Efficiency Tess During he period of crisis he ADF es in Shenzhen and Shanghai sock exchanges are , and , which are lesser han heir criical values of , , a 1%, 5%, 10% significance levels respecively. So he null hypohesis is rejeced and daa series are considered non saionariy by acceping alernaive hypohesis. Same resuls are obained by robus esing. Index ADF es Saisics Wih 5 lags Table 4 (A): Tes saisics wih inercep and no rend DF GLS es Saisics Wih 5 lags PP uni roo es (Newey Wes Bandwih) KPSS (Newey Wes Bandwih) SHZ SHN Table 4 (B): Criical values Level ADF Tes DF GLS Tes PP uni roo es KPSS Tes 1% % % The es saisics wih inercep and rend for he period of crisis are also no oo differen. The saisical values of all ADF, DF GLS, PP and KPSS wih drif and rend are lesser han heir criical values (Table 5) a all significance levels. So here again he sudy rejecs he null hypohesis and consider ha he daa series on boh exchanges as non saionary. Index ADF es Saisics Wih 5 lags Table 5 (A): Tes saisics wih inercep and rend DF GLS es Saisics Wih 5 lags PP uni roo es (Newey Wes Bandwih) KPSS (Newey Wes Bandwih) SHZ SHN ASIAN JOURNAL OF MANAGEMENT RESEARCH 98

10 Table 5 (B): Criical values Level ADF Tes DF GLS Tes PP uni roo es KPSS Tes 1% % % Conclusion Analysis of Marke Efficiency is an imporan concep for he invesors who wish o hold inernaionally diversified porfolios. Wih increased movemen of invesmens across inernaional boundaries owing o he inegraion of world economies, he undersanding of efficiency of he emerging markes is also gaining greaer imporance. The resuls of he sudy shows ha Chinese sock marke is weak form efficien and daa series are non saionary, here exis uni roo in daa series. I means ha Chinese sock marke is following he random walk process. The invesors can no generae excess profis by using and observing pas behavior of sock price movemens. Here is no significan difference in marke efficiency in boh periods (before crisis and during crisis). One good possible way o enhance he marke efficiency is o inroduce financial innovaion in he emerging sock markes. New financial producs creae he opporuniies for invesors o mobilize heir savings and very useful in breaking he relaion beween originaion and ownership. When new financial insrumens come ino marke, his will provide opporuniies o he invesors o allocae heir risks in differen securiies and in differen invesor classes. This financial innovaion is also very helpful in reducing he cos of capial and allocaion of capial a is maximum, which will finally resul in maximum uilizaion of sources and enhance marke efficiency a is bes. I is observed in major developed world markes ha when new financial insrumens and echnological advancemens come ino marke, i booss he marke efficiency significanly. The mos common examples of hese innovaive advancemens are he markes of Europe, USA, and Ausralia, where hese financial innovaions conribue a lo in heir economic growh. Thus, financial innovaions in emerging financial secor in China as whole are beneficial. The recen global financial crisis remind he world ha his financial innovaions are mixed blessings, no risk free and also has is shorcomings. References 1. Abraham, A., Seyyed, F. J., and Alsakran, S. A. (2002). Tesing he random behavior and efficiency of he Gulf sock markes. The Financial Review, Vol. 37.No.3. pp Andrew W. Lo, A. Craig Mac Kinlay (1988). Sock Marke Prices Do No Follow Random Walks: Evidence from a Simple Specificaion es. The review of financial sudies, Vol. 3, pp Appiah Kusi, J. and Menyah, K. (2003). Reurn predicabiliy in African sock markes. Review of Financial Economics, Vol. 12. No.3, pp ASIAN JOURNAL OF MANAGEMENT RESEARCH 99

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