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Islam Sethapong Watanapalachaikul Empirical Finance Modelling and Analysis of Emerging Financial and Stock Markets With 53 Figures and 56 Tables Springer-Verlag Berlin Heidelberg GmbH Series Editors Wemer A. Miiller Martina Bihn Authors Dr. Sardar M. N. Islam Dr. Sethapong Watanapalachaikul Centre for Strategic Economic Studies Victoria University PO Box 14428 Melboume City MC VIC 8001 Australia [email protected] sethapong. watanapalachaikul @vu.edu.au ISSN 1431-1933 ISBN 978-3-7908-1551-1 ISBN 978-3-7908-2666-1 (eBook) DOI 10.1007/978-3-7908-2666-1 Cataloging-in-Publication Data applied for Library of Congress Control Number: 2004109408 This work is subject to copyright. Ali rights are reserved, whether the whole or part of the material is concemed, specifically the rights of translation, reprinting, reuse of illustrations, recitation, broadcasting, reproduction on microfilm or in any other way, and storage in data banks. Duplication of this publication or parts thereof is permitted only under the provisions of the German Copyright Law of September 9, 1965, in its current version, and permission for use must always be obtained from Physica-Verlag. Violations are liable for prosecution under the German Copyright Law. © Springer-Verlag Berlin Heidelberg 2005 Originally published by Physica-Verlag Heidelberg 2005 The use of general descriptive names, registered names, trademarks, etc. in this publication does not imply, even in the absence of a specific statement, that such names are exempt from the relevant protective laws and regulations and therefore free for general use. Softcover Design: Erich Kirchner, Heidelberg SPIN 11014270 88/3130IDK-5 4 3 2 I 0-Printed on acid-free and non-aging paper Foreword This book makes two key contributions to empirical finance. First it provides a comprehensive analysis ofthe Thai stock market. Second it presents an excellent expositionofhow modem econometric techniques canbe utilised to understand a market. The increasingglobalisation ofthe world's financial markets has made our un derstanding ofthe risk-return relationship in a broader range ofmarkets critical. This is particularly so in emerging markets where market depth and liquidity are majorissues.OnesuchemergingmarketisThailand.TheThaicapitalmarket isof particular interest given that it was the market in which the Asian financial crises commenced.As such anunderstanding oftheThai capital market via study ofthe pre and post-crisis periods enables one to shed light on one ofthe major financial marketsevents ofrecenttimes. This book provides a quantitative analysis of the Thai capital market using some very useful and recent econometric techniques.The book provides an over view ofthe Thai stock market in chapter 2.Descriptive statistics and time series models (moving average, exponential smoothing, ARIMA) arepresented in chap ter 3followedby market efficiency testsbased onautocorrelations inchapter 4.A richer set ofmodels is then considered inchapters 5 through 8. Chapter 5 finds a cointegrating relationship between macroeconomic factors and stock returns. Chapter 6findsevidence ofaspeculativebubblepre-crisisbutnotpost-crisis.This is a particularly interesting finding. Chapter 7 finds evidence ofcalendar anoma liesinThai stockreturns.Chapter 8fitsarange ofmodelsfromtheGARCH fam ilytoThai stockmarket volatility and findsthese modelsdo agoodjob incharac terisingvolatility. This book should be of special interest to students, researchers, academics, practitioners, and policy makers in the areas of finance, banking, economics and development management. ProfessorRobertBrooks Professor ofFinancial Econometrics Dean(Research & Innovation) RMITBusiness RMIT University,Australia Abstract, Preface and Acknowledgement Empirical finance (especially financial studies using financial econometrics) is becoming a verypopular academic discipline in finance.An evidence of this fact is Professors Engle and Granger's Nobel prize this year (2003) for their work in financial econometrics. Applying econometric methods to investigate empirical finance(tounderstandtheempirical characteristicsofthe financialmarket)andits components such as the stock market is an important area of study in finance not only for academic investigation, but also for policy formulation and investment planning purposes. This book undertakes studies on some common financial econometric methods and issues, some of which havebeen studied by Professors Engle and Granger, in the context of emerging financial markets of developing countries.This isanessentialeconometricstudyofempirical developmentfinance for an exploration of the characteristics of the financial market of the emerging stockmarketsofdevelopingcountries. There are substantial differences in the operation and characteristics of finan cial markets in developed and developing countries in terms of efficiency, stabil ity,andtheeffectivenessinpromotingeconomicdevelopment.There aredifferent views about the performance and characteristics of the financial markets in both thesetypes ofeconomies. Oneviewstressesthepossibility forefficientoperation of the market leading to efficient allocation of resources while the others high lights the real life evidence of market failures, market inefficiency, the existence ofspeculation,bubbles, etc. Thisstudyundertakesanempiricalstudyofthechar acteristicsofa developingAsian(Thai)financialmarketasacasestudyby apply ing the methods of financial econometrics to investigate whether and how these characteristicscorrespond withtheseviews. Emphasis isplaced onunderstanding those specialcharacteristics of thefinancialsystemofdevelopingcountries which can cause financial market failures, and the existence of market imperfections suchasasymmetricinformation,adverseselectionandmoralhazard. Thepresentbook ispossiblythemostcomprehensivestudyofcrucialissuesaf fecting the stock market including valuation, predictability, volatility, anomaly andmarketefficiency. Perhaps,nosuchstudyhasexistedpreviously,makingthis bookagenuinecontributiontotheliterature. The stock marketplays a major role ina developing economy's financial sys tem.While focusing onThailand as acase study, this studyprovides both the re searcherinquantitativefinancialeconomicsandthestockmarketinvestor,withan understanding of the financial issues of developing economies in emerging stock markets especially the Asian stock market which have similar characteristics as those of the Thai stock market. The financialissues studied in this book include VIII Abstract,PrefaceandAcknowledgement market efficiency, valuation, predictability, speculative bubbles, anomalies and volatilities,among others. The findings ofthis explorative research ofthe above forms provide informa tion necessary for understanding the state offinancial development in a country and formulatingpolicies forcorporate finance,choosingbetween thestock market vsbank based financial development strategies, and financing economic develop ment. A standard set ofall financial econometric methods and models including de scriptive statistics and time series econometric methods have been adopted inthis study. Many contemporary techniques, approaches and models are used and in cludesimplemultivariate regression, runtest,ACF model, multi-factor model,ex ponential smoothing, Holt Winter's model, ARIMA, TSMM, Duration Depend ence Test, Weibull Hazard, time-series regression model with dummy variable, and GARCH type models. They are developed in order to examine the financial econometricissues oftheThai stockmarket. Data fortheperiod of 1975to 2001 areusedtoundertaketheseeconometricmodelingexercises. The empirical investigations provide useful information about thebehaviour of the Thai financial time series data related to the fair game, white noise, random walk, martingale, stationarity, error correction, cointegration and diffusion proc esses. In terms ofthe operation ofthe Thai financial system and stock market, this studyprovides someusefulinsights. Allthecharacteristics oftheStockExchange of Thailand analysed in terms ofmarket index prices and returns reveal evidence ofinefficiency in the market. Substantial empirical evidence supports the rejec tion ofthe hypothesis ofthe stock price process being white noise in both the short-term and long-term analysis. The notion ofexisting market inefficiency is supported by the presence ofrational bubbles, anomalies and volatility. Anoma liesinthe stockmarket (in theformofMonday andtheJanuary effects) wereevi dent during the 1992-1996 (the pre-crisis) and 1997-2001 (the post-crisis) peri ods. The existence ofspeculative bubbles in the stock market was confirmed by the test models. In addition, volatility in the stock price was high in 1992, 1993, 1997and 1998after theThai financial crisis. High volatility in stock prices and returns was also found inJanuary,February and December. Empirical estimation ofstockvaluation modelsreveals thatmanyeconomic factorsarethedeterminants ofthe value ofThai stock such as the interest rate, bonds yield, foreign exchange rates,price earningratio,marketcapitalization,andtheconsumerpriceindex. These characteristics ofthe emerging stock markets are due to the level ofde velopment of the financial systems, institutions and socioeconomic structure in developing countries. Some welfare economics aspects offinance covering these issuesarealsostatedinthisstudy. The findings ofthis study provide justification for governments in developing countries adopting financialpoliciesdesigned to evolve adeveloped, efficient and social welfare maximising financial market which can ensure efficient allocation offinancialresources. Suggestions for further study inthis area and directions for futureresearch are alsoincluded. Abstract,PrefaceandAcknowledgement IX This study argues for treating empiricaldevelopmentfinance as aseparate dis cipline in finance since this description can provide information, both analytical and empirical, useful forproper understanding the development process in devel opingcountries. Sincethisbook isarigorousresearch studyinfinance,itcanbeused asarefer ence book by researchers, academics, practitioners, policy markers, and post graduate students intheareaoffinance,financialeconometrics, financialeconom ics, monetary economics, and development economics. It can also be used as a textbook onempirical financeorfinanceintheemerging markets orasareference orasanadditionaltextforafinancesubjectattheMasters orDoctoral level. The authors wish to thank M. Kumnick, R. Gupta and M. Clarke forproviding research and editorial assistance inpreparing this book. This book has benefited from the generosity ofN.Billington and P.Sheehan formaking the necessary re sources available and sharing their knowledge, experience and encouragement in bringing ittocompletion. SardarM.N.IslamandSethapongWatanapalachaikul CenterforStrategicEconomic Studies VictoriaUniversity Melbourne,Australia April2004 Contents Foreword V Abstract,Prefaceand Acknowledgement.. VII 1Introduction 1 1.1Introduction 1 1.2FinancialSystemand Issues 2 1.3Characteristics ofthe EmergingStockMarketsinDevelopingCountries 3 1.4FinancialEconometrics: Methodsand Models 5 1.5The ThaiFinancialSystemand the EmergingStockMarket 5 1.6LimitationsofExistingLiteratureand theMotivation 6 1.7The Objectivesofthe Study 7 1.7.1Objectives 7 1.7.2WelfareEconomicsofFinance: Policies and Institutions 7 1.8Contributions ofthis Research 8 1.9EconometricMethodologiesand SourcesofData 8 1.9.1EconometricMethodologies 8 1.9.2Sources ofData and ComputerPrograms 9 1.10 Structureofthe Book 10 1.10.1 ChapterStructure 10 1.10.2 GeneralStructure 11 2 TheThaiFinancialSystem: Characteristicsof theEmergingThaiStock Market 13 2.1 Introduction 13 2.2Financialand CapitalMarkets 13 2.2.1The Central Bankand CommercialBank 15 2.2.2Moneyand Capital Markets 16 2.2.3ForeignExchangeMarket 17 2.2.4 StockMarket: GeneralCharacteristics 18 2.3RecentIssues 21 2.3.1 FinancialLiberalisation 21 2.3.2Economic Crisis 21 2.3.3Focus onForeignCapitalFlows 22 2.3.4UnstableExchangeRate inan OpenEconomy 22 2.3.5MarketImperfection 23 XII Contents 2.4 Conclusions 23 3DescriptiveStatistics and GeneralCharacteristicsoftheStockMarket 25 3.1Introduction 25 3.2Descriptive Statistics 25 3.3Univariate Time SeriesModelling 31 3.3.1MovingAverage 33 3.3.2ExponentialSmoothing 36 3.3.3HoltWinters' MultiplicativeMethod 44 3.3.4ARIMA Models 49 3.5 Implicationsand Empirical Characteristics 50 3.6Conclusion 51 4MarketEfficiencyModels and Tests 53 4.1Introduction 53 4.2Market EfficiencyHypothesis 54 4.2.1The Concept 54 4.2.2EMH andTime SeriesBehaviour 56 4.3StockMarket EfficiencyTests 58 4.3.1RunTest 58 4.3.2AutocorrelationFunctionTest 60 4.4The Market EfficiencyoftheThaiFinancialSystem 62 4.5 Conclusions 63 5StockValuationModels 65 5.1Introduction 65 5.2 Literature Review:Why aMultifactor Model? 66 5.2.1The Rational Valuation ModeL 66 5.2.2 Capital Asset Pricing Model(CAPM) 68 5.2.3The Arbitrage PricingTheory 74 5.2.4 Estimation ofthe ValuationModel 76 5.2.5Limitation ofCurrent Models 76 5.2.6RelationbetweenMacroeconomicFactors and StockPrices 77 5.3Models, EconometricsMethodologyandData 77 5.3.1Variable Selection,MacroeconomicandInternationalFactors 77 5.3.2Multi-FactorModel. 80 5.3.3Data 80 5.4Results and Implications forValuation 81 5.4.1 UnitRoot and CointegrationTest 81 5.4.2The FactorsDeterminingtheValues oftheStocks 86 5.5 CointegrationTest ofthe Six-VariableModel 87 5.6The Real Value ofStocks 88 5.7Conclusions 88 6Modelsfor RationalSpeculativeBubbles 91 6.1 Introduction 91