Any decision carried out by the management of any organization needs adequate, accurate and precise information, on the basis of that information the management procures their analysis and undertake decision. If decision to be taken involves any financial aspect, this increases the scope and accuracy of the information. Financial decisions require adequate and accurate information; therefore, it is important that the behaviour of individual market is investigated for informed financial decision making, Oguzusy and Guiven (2003).
In this respect many theories were presented. One of them is about the market efficiency which is termed as efficient market hypothesis (EMH). The concept of market efficiency had been anticipated at the beginning of the century by Bachelier (1900) in his dissertation. Fama (1970) classified market efficiency in three categories namely, weak form, semi strong form and strong form of efficiency; weak form of efficiency which defines as one can’t earn abnormal return by doing technical analysis of the market or of a particular stock. Technical analysis means predicting future prices by studying historical prices of a particular share or a market. The Second form of efficient market hypothesis (EMH) is semi-strong form of efficiency. This form of market efficiency makes impossible for an investor to earn extra return on security by knowing the publicly available information; this includes company’s financial results, any particular event or news which affects the company the share prices adjust rapidly with these new publicly available information therefore excess return can’t be earn by trading on that information. The last form of efficient market hypothesis (EMH) is the strong form of efficiency and can be define as share prices reflects all public and private information (insider information) and consequently it is not possible for a stock holder to earn extra return on the basis of these information.
According to efficient market hypothesis (EMH) the stock prices in an efficient market fully reflect their investment value Ajayi, Mehdian Perry (2004). The security pricing process instantaneously impound the available information in an efficient market and it is not possible to beat an efficient market that by using data mining, trading strategy or by any technical analysis to get consistently abnormal returns.
Efficient market hypothesis (EMH) assumed that
(1) All investors have cost-less access to currently available information about the future.
(2) They are good analysts; and
(3) They pay close attention to the market process and adjust their holdings appropriately.
Many models including Augmented Dickey Fuller (ADF) unit root test, variance ratio test (VR), Ljung Box Q-statistics, and Durbin Watson‘d’ statistics have been based on this concept of informational efficiency of capital markets. However the late seventies and the eighties brought in evidences questioning the validity and highlighting various anomalies related to the Stock market efficiency. There are many focused studies that demonstrate the possible trading strategies yielding abnormal rates of return using the historical data and publicly available information ruling out the efficacy of markets. The empirical studies evidencing the inefficiency are broadly related to the following:
(1) The low price-earning (P/E) effect: Researches show that stocks with low price earning (P/E) ratios earned more for investors, which is contradictory to Efficient Market Hypothesis (EMH). Fama and French (1995) found that market and size factors in earnings help explain market and size factors in returns.
(2) The small firm and neglected firm effects: Banz (1981), Reinganum (1981) and other researchers show the size or small-firm effect in stock return. Their analysis support the evidence that small firm with low capitalization can earn higher returns than the large firm with large capitalization.
(3) Market over and under reaction: DeBondt and Thaler (1985, 1987) present evidence that is consistent with stock prices over reacting to current changes in earnings. They report positive (negative) estimated abnormal stock returns for portfolios that previously generated inferior (superior) stock price and earning performance. This could be construed as the prior period stock price behaviour over reacting to earnings developments (Bernard, 1993).
(4) The January effect: The January effect in stock returns was documented by many researchers. Their analysis suggested that January has a highest return as compared to other months. January effect was first discovered by Rozeff and Kinney (1976) for US stock markets. Later other researchers like Gultekin and Gultekin (1983), Chang and Pinegar (1986) documented the same result for other countries stock markets.
(5) The week day effect: This refers to the observation that stocks return are not independent of the day of the week effect. A notable anomaly is the Monday effect in daily stock returns, which suggests that stock returns are significantly lower or negative on Mondays relative to other week days. This ‘Monday effect’ has been extensively examined not only in U.S. asset markets but in international markets as well, for example French (1980), Lakonishok and Levi (1982), Mehdian & Perry (2001) and Lakonishok & Smidt (1988).
In week day effect the last trading day that is Friday was characterized with a positive return and the first trading day that is Monday is characterized with a low or negative return. Later this interesting study was also carried out on other countries stock markets and the researchers found out the same result, but still few studies has been done on emerging Asian stock markets.
Karachi Stock Exchange (Kse)
The Karachi Stock Exchange abbreviated as KSE is a stock exchange based in Karachi, Pakistan. It was founded in 1947 and is country’s largest and oldest stock exchange, with both Pakistani and overseas listings. It is also the second oldest stock exchange in South Asia. From its inception in 1947, it has done an amazing progress. In 1950s, only 05 companies listed and 90 members were there on the exchange and at the end of 2007 the number of listed companies increased by 666 which make a total of 671 listed companies and the member on the exchange goes up from 90 to 200 during these years. Its current premises are situated in the heart of Karachi’s Business District, on Stock Exchange Road.
KSE is the biggest and most liquid exchange. It was recognized worldwide for performing well in 2002 by ‘Business Week’ magazine. US newspaper, USA Today, termed Karachi Stock Exchange (KSE) as one of the best performing bourses in the world. As of December 20, 2007, 671 companies were listed with the market capitalization of Rs.4364.312 billion (US$ 73 Billion) having listed capital of Rs.717.3 billion (US$ 12 billion). In the same year, the KSE 100 Index reached its ever highest value and closed at 14,814.85 points.
The trading hours are from 9:45am to 2:15pm on weekdays and 9:30am to 1:30pm on Friday.
The beginning of the exchange was very low with an index of 50 shares only. As the market grew, a delegate index was needed. On November 1st, 1991 the KSE-100 index was introduced and till present it is the most generally accepted measure of the exchange.
The need to reconfirm for all share indexes was felt in 1995 and to provide the beginning of index trading in future. And this was achieved on 29th of August, 1995, constructing all share indexes and introduced on 18th of September, 1995. Foreign interests were very active on KSE in 2006 and the interest continued in 2007 also. According to the estimates given by State Bank of Pakistan, foreign investment in capital markets total about US$523 Million. According to a research analyst in Pakistan, around 20% of the total free float in KSE-30 Index is held by foreign participants. There is a plan to build high rise building for the KSE as a new direction to future investments. The decision was taken by the board of directors, Karachi stock exchange (KSE). Disputes between investors and members of the Exchange are resolved through deliberations of the Arbitration Committee of the Exchange.
Kse – 100 Index
Karachi Stock Exchange 100 Index (KSE-100 Index) is a benchmark and stock index used to compare prices overtime. In determining representative companies to compute the index, companies with the highest market capitalization are selected. To ensure full market representation, the company with the highest market capitalization from each sector is also included. The list of 100 companies listed in Karachi Stock Exchange is presented in Table # 01.
The Karachi Stock Exchange (KSE) has also launched the KSE-30 Index with base value of 10,000 points, implemented from September 1, 2006. The main feature of this index is that it based only on the free-float of shares, rather than on the basis of paid-up capital which differ it from the other indices. Unlike the Karachi Stock Exchange (KSE) which represents total return of the market, KSE-30 index is adjusted for dividends and right shares. That is, when a company announces a dividend, the other indices at Karachi Stock Exchange (KSE) are not reduced for that amount of dividend. Whereas KSE-30 Index is adjusted for dividends and right shares only
Table # 01
|List of 100 Companies listed In Karachi Stock Exchange – 100 Index|
|No.||Company Name||No.||Company Name|
|1||Pakistan Refinery||51||Pakistan Telecom. Co.Ltd|
|2||EFU General Ins||52||Sui North Gas|
|3||Pakistan Reinsur||53||New Jubilee Insurance|
|4||EFU Life Assurance||54||Mybank Limited|
|5||Dawood Herc.||55||WorldCall Telecom|
|6||Ist.Capital Securities||56||D.G.Khan Cement|
|7||Mari Gas||57||Pakistan State Oil|
|8||Siemens Pakistan||58||PICIC Growth|
|9||Bata (Pakistan)||59||Fauji Cement|
|10||Adamjee Insurance||60||Standard Chartard Bank|
|11||Attock Refinery||61||IGI Insurance|
|12||Jahangir Siddiqque Co.||62||Sui South Gas|
|13||Pak.National Shipping Corp.||63||Karachi Electric Supply Corp.|
|14||Bank Al-Falah||64||Shell Pakistan|
|15||Meezan Bank||65||Wazir Ali|
|16||Bannu Woollen||66||Samin Textiles|
|17||JS Global Cap.||67||Bestway Cement|
|18||Rafhan Maize||68||Maple Leaf Cement|
|19||Habib Metro Bank||69||Pioneer Cement|
|20||Nestle Pakistan||70||Javedan Cement|
|21||Pakistan Elektron||71||Fazal Textile|
|22||Lucky Cement||72||Pak.PTA Ltd.|
|23||Pakistan Tobacco||73||ABN AMRO Bank|
|24||MCB Bank||74||NIB Bank|
|25||Bank AL-Habib||75||Bosicor Pakistan|
|26||Pakistan Petroleum||76||Saudi Pak Bank|
|27||Attock Petroleum||77||Pakistan Cement|
|28||Engro Chemical||78||Agriautos Industries|
|29||National Refinery||79||AL-Ghazi Tractors|
|30||ICI Pakistan||80||Allied Bank|
|31||Colgate Palmolive||81||Arif Habib Securities|
|32||Abbott (Lab)||82||Askari Bank|
|33||Habib Bank Ltd||83||Atlas Honda|
|34||Attock Cement||84||Kot Addu Power Company|
|35||Azgard Nine||85||Lakson Tobacco|
|36||Bank of Punjab||86||National Bank of Pakistan|
|37||Fauji Fertilizers Bin||87||Nishat Mills|
|38||Fauji Fertiliz||88||Oil and Gas Development|
|39||Faysal Bank||89||Orix Leasing|
|40||Ghani Glass||90||Pakistan International Airlines|
|42||Habib Modarba||92||Pak Oilfields|
|43||Habib Sugar||93||Pak Services|
|44||Hub Power||94||Pak Suzuki|
|45||Ibrahim Fibres||95||Pakistan Intn`l Container Ter.|
|46||Indus Motor||96||Soneri Bank|
|47||International Industries limited||97||Thal Limited|
|48||JS Investment||98||UniLever Pakistan|
|49||Kohinoor Energy||99||Unilever Foods|
|50||Cresent Commercial Bank||100||United Bank|
(Source: Karachi Stock Exchange)
The index was launched in late 1991 with a base of 1,000 points. By 2001, it had grown to 1,770 points. By 2005, it had skyrocketed to 9,989 points. It then reached a peak of 12,285 in February 2007. KSE-100 index touched the highest ever benchmark of 14,814 points on December 26, 2007. The graph of last 10 years of KSE growth and index points is shown. The graph clearly shows the progress and continuous increment.
Free Float Index: In order to introduce a free float index that is representative of the market, the KSE- 30 Sensitive Index was implemented with effect from September 1, 2006. The need for a market representative free float index was long felt as the capitalization weighted KSE 100 Index strongly tilted to a few scripts. Free float is based on the proportion of shares readily available for trading to the total shares issued and excludes the locked in shares. The criterion for the selection of scripts on KSE-30 index was revised on 15 February 2007 in line with international best practices to include the impact cost as a measure to gauge the liquidity of scrip.
This study is about testing the semi-strong form of Efficient Market Hypothesis (EMH) on the annual earnings announcement for the selected companies, listed on Karachi Stock Exchange (KSE) by using event study methodology (Fama et al. 1969; and Brown and Warner 1980, 1985).; Following this chapter the study is divided into six more chapters, they are;
(1) Chapter two includes detailed Research aims and objectives, it also comprises of main problem and their sub problems; hypotheses of the study are also being discussed in this chapter.
(2) In the third chapter, Review of relevant theoretical and empirical research has been done. In this chapter we have concluded that what has been done so far in this area of study both theoretically and empirically.
(3) Fourth chapter covers Research methodology, data sources and method of sampling for the data. Methodology includes formulae and tests which are being used to test semi-strong form of efficient market hypothesis (EMH) on Karachi Stock Exchange (KSE).
(4) Fifth chapter includes Research results and/or findings with supporting evidence.
(5) Sixth chapter includes the research conclusions.
(6) The seventh and the last chapter comprise of Recommendations; made with the help of Research results and/or findings.
Scope And Limitation Of The Study
The material in this dissertation to the best of my knowledge do not contain any previously published or written documents by another person except where due acknowledgement is made in the research itself.
If any errors found in the calculations made for this research that will be the sole responsibility of the writer.
Statement Of Ethics And Originality
Due to time constraint and non availability of the company’s earnings announcement data from the Karachi stock exchange web site before 2004 the study is being carried out for just three years which includes 2005, 2006 and 2007.
Moreover during the period of study which is year 2005, 2006 and 2007 there are few companies eliminated due to the non availability of the required data to carry out the calculations.
Due to the limited availability of econometrics experts for guidance irrespective of the new sophisticated models for event studies, conventional models were used in this study despite the fact they have less predictive power than the other latest models.
Aims, Objectives And Hypothesis Of The Study
The following are the Aims & Objectives of the study:
- To check whether the Semi-Strong form of Efficient Market Hypothesis (EMH) is valid for Karachi Stock Exchange` 100 – 100 Index (KSE – 100 Index).
- To examine the stock market reaction (KSE) to Annual Earnings Announcements.
The research is comprises with one main problem which is further divided into three sub problems each problem has its own hypothesis and to be solved separately.
Test whether semi-strong form of efficiency exists on Karachi Stock Exchange (KSE) or not.
Sub Problem – One
Whether the annual earnings announcement affect complete on the day of announcement?
We will calculate the normal return and the expected return and if it is close to zero; we will say that the annual earnings announcement affect complete on the day of announcement
Sub Problem – Two
Share holders could not earn extra return; before, and after the announcement.
We would first take the average of abnormal return and then cumulate the average abnormal return.
In case where the AARs and the CAARs are closed to zero we will conclude our results that, investor or the share holder are not able to earn abnormal return by trading on event which is earnings announcement.
Sub Problem – Three
The Average Abnormal Returns (AARs) are random.
We used Runs test to analyze the randomness in the behavior of Average Abnormal Returns (AARs). To check whether the average abnormal returns occur by chance or not, we carried out Runs test. In case where the observed numbers of runs are significantly different from the expected number of runs, we will conclude our finding as Average Abnormal Returns (AARs) do not occur randomly. Alternatively, if these results were not statistically significant, we say that Average Abnormal Returns (AARs) do occur randomly. We carried out runs test on Average Abnormal Returns (AARs) before and after the event day and also for the event window.
Since the study empirically examine the Karachi Stock Exchange`s 100 Index reaction to Annual Earnings Announcement and the hypothesis being tested are:
Hypothesis For Sub Problem One
HO: Our null hypothesis for sub problem – one is that the stock prices reactions in response to the annual earnings announcement complete on the announcement day in addition to that, abnormal returns can`t be earn by the investors on stocks by trading on stocks after the announcement day.
HO: Rit = AR = 0
H1: Rit = AR
For testing above hypothesis we compute the estimated return for the event window and then compare it to the actual return, the estimated return will be calculated by using following equation;
E (Rit) = αi + βi Rmt
Under the null hypothesis if the estimated return of a stock is closed to zero we will accept the null hypothesis and if it is not than we will reject our hypothesis and bring to a close; that announcement do affect on returns.
Hypothesis For Sub Problem Two
HO: Our null hypothesis for sub problem – two is that returns are close to zero for average abnormal returns and their respective cumulative average abnormal returns for the selective securities in the study
HO: AAR ≈ CAAR = 0
H1: AAR ≈ CAAR
To test the above hypothesis first we will calculate the average abnormal return (AAR) and then cumulative average abnormal return (CAAR) with the help of the following formulae;
For Average Abnormal Return
AAR it = i=1 .
i = the number of securities in the study;
N = total number of securities.
t = the days surrounding the event-day
For Cumulative Average Abnormal Return
CAARt = Σ AARit Where, t = -30,…0, … +30.
t = -30
If the average abnormal return and the cumulative average abnormal return are close to zero than we accept our null hypothesis otherwise we will reject it.
2.2.3 Hypothesis for Sub Problem – Three
HO: Our null hypothesis for sub problem – three is that the difference between the no. of positive and negative average abnormal returns as not significant and they occur randomly.
HO: Z = 0
The null hypothesis of the test is that the observed series is a random series. A run is defined by Gibbons (1985), as
“A succession of identical symbols which are followed or preceded by different symbols or no symbol at all”
The run test is another approach to test and detect statistical dependencies (randomness). The number of runs is computed as a sequence of the price changes of the same sign (such as; + +, – – , 0 0).
When the expected number of run is significantly different from the observed number of runs, the test rejects the null hypothesis that the daily returns are random. The run test converts the total number of runs into a Z statistic. For large samples the Z statistics gives the probability of difference between the actual and expected number of runs. The Z value is greater than or equal to + 1.96, reject the null hypothesis at 5% level of significance (Sharma and Kennedy, 1977).
There have been a lot of studies conducted on Efficient Market Hypothesis (EMH), a concept; developed by Fama (1960) and divided capital market into three parts on the basis of its efficiency namely weak, semi-strong and strong form. For the event study, which is linked with semi – strong form of market efficiency; below first we discuss the theoretical foundations and after that, the empirical evidence.
The origins of the Efficient Market Hypothesis (EMH) can be traced back to the work of two individuals, Eugene F. Fama (1960) and Paul A. Samuelson (1960). Remarkably, they independently developed the same basic concept of market efficiency from two rather different research agendas. These differences would drive them along two distinct trajectories leading to several other breakthroughs and milestones, all originating from their point of intersection, the Efficient Market Hypothesis (EMH). The EMH state that in an efficient market where many well-informed and intelligent investors operates, the stock price imitates all the existing information and no other information or analysis can be used to earn abnormal returns.
The arguments of Fama (1965) form the theoretical foundation for the Efficient Market Hypothesis (EMH), which persuasively reasons that in an efficient and active market consisting of many well-informed investors, equity prices will appropriately reflect the effects of information based on present and future expected events. The strong form of the hypothesis asserts that the current market prices fully reflect all private (insider) and public information. In other words, insiders shouldn`t be able to earn excess returns from privileged asymmetric information. The strong form of the hypothesis represents an absolute standard, and in practice, market demonstrates only a certain degree of efficiency.
Efficient Market Hypothesis (EMH) claims that speculative market prices fully and immediately reflect all available relevant information. Fama categorised information as: publicly available information, information that eventually becomes public, insider information. Event studies are used in tests of Efficient Market Hypothesis (EMH) to ask whether prices incorporate information fully on the day that the information is revealed. If Efficient Market Hypothesis (EMH) holds, the information about the event should be incorporated into prices before or on the day of the event itself. There should be no impact on returns after the event
“There was little evidence on the central issues of corporate finance, now we are overwhelmed with results, mostly from event studies”
(Fama, 1991, p. 1600)
Event study analyses are typically used for two different purposes firstly as a test of semi-strong form market efficiency; and secondly as, assuming that the market efficiency hypothesis holds, as a tool for examining the impact of some event on the wealth of firms’ shareholders. Event studies measure security price changes in response to events. A single event study typically analyzes the average security price reaction to instances of the same type of event experienced by many firms. For example, the event could be the announcement of a merger. The event date can vary from one security to another in the same study, with dates measured in “event time”. Event studies have been used in a large variety of studies, including [mergers and acquisitions], earnings announcements, debt or equity issues, corporate reorganizations, investment decisions and corporate social responsibility MacKinlay (1997), McWilliams & Siegel (1997).
The debate about efficient markets has resulted in hundreds and thousands of empirical studies attempting to determine whether specific markets are in fact “efficient” and if so to what degree. Many novice investors are surprised to learn that a tremendous amount of evidence supports the Efficient Market Hypothesis (EMH).
Since the late 1960s, the enormous study in the finance and accounting literature has recognized evidence of relationship between accounting reports and market reactions. Fama (1970) described an efficient market as having prices that “fully reflect” all available information. Beaver (1981) offers a definition of market efficiency based on the information distribution when investors have mixed beliefs.
Accounting reports probably are one of the sources of public information. Ball & Brown (1968) examine the relationship between the accounting reports & stock prices &. Their results show that the market reacts to unexpected earnings as though the market participants had access to the good or bad news prior to the availability of this news to the market. They estimate that only 10 to15 percent of the market reaction takes place during the announcement month. Using another approach, similar results are also found in the work of Ball and Brown (1968) they examined price changes surrounding the announcement of a firm’s annual earnings and found that the stock market reacts quickly to annual earnings announcements. Ball (1992) and Bernard & Thomas (1989) and (1990), documented significant delays in the adjustment of stock prices to quarterly earnings announcements.
Developed countries of the world such as the USA, the UK, and Australia, etc. the amounts of researches on Efficient Market Hypothesis are extensive. Fama, Fisher, Jensen and Roll (1969) conducted the first study on semi-strong form of Efficient Market Hypothesis (EMH). They examined the behaviour of abnormal returns at the announcements of stock splits and found that the market reaction is significant prior to the stock split announcement. Jordan (1973) assessed the behaviour of security prices surrounding the quarterly earnings announcements and found that stock market is efficient in the semi-strong form.
In Asia until now some researches has been done. Kong, S. and Taghavi, M. (2006) study the Effect of Annual Earnings Anno