Cost of Trading, Effective Liquidity Measures, and Components of the Bid-Ask Spread in the Emerging Stock Market of Ukraine Anna Serdyuk PhD The University of Edinburgh 2010 THE UNIVERSITY OF EDINBURGH ABSTRACT OF THESIS Regullatiion 3.1.14 of the Postgraduate Assessment Regullatiions for Research Degrees refers These regullatiions are avaiillablle viia: http://www.acaffaiirs.ed.ac.uk/Regullatiions/Assessment/Home.htm Name of Candidate: Anna Serdyuk Degree: PhD Title of Thesis: Cost of Trading, Effective Liquidity Measures, and Components of the Bid-Ask Spread in the Emerging Stock Market of Ukraine Number of Words: 80,000 The thesis studies aspects of the cost of equity trading in the emerging stock market of Ukraine. The market is quite new (opened in 1997 but started to operate actively only in 2004) and little research on this market has been done so far. The market appears to offer lucrative investment opportunities that attract attention of both Ukrainian and foreign investors but the cost of trading Ukrainian stocks is quite high and can considerably decrease the returns to investors. The empirical part of the thesis is based on the transactions data from the main trade floor in Ukraine, PFTS, for 59 Ukrainian stocks during 2004-2006. The cost of equity trading in Ukraine is found to be quite high compared to many other stock markets, both developed and emerging. An in-depth study has shown that the medium-sized trades are the cheapest to execute, followed by large and then small trades. The reason for the pattern is seen in the price improvement suggested by brokers to the larger, more valued customers in order to keep the business with them and is in line with the findings in other literature for dealership markets (Reiss and Werner (1996), Hansch et. al (1999), and Huang and Stoll (1996)). The average cost of institutional sale trades exceeds the average cost of institutional buy trades at any market condition (falling, neutral, or rising), which is a puzzling result given that sales are often found in the literature to be more expensive in falling market, while purchases are more expensive in rising market. The efficacy of a number of measures of liquidity is studied. In line with findings for other emerging markets, it is shown that the proportion of zero daily returns (Lesmond (1999)) and the proportion of no-trading days are the most reliable liquidity measures for the Ukrainian stock market. Turnover, a measure widely applied in literature for developed stock markets, has a very small power for measuring liquidity in Ukraine. The spread components are estimated by applying three spread decomposition models most frequently referred to in literature: Stoll (1989), Glosten and Harris (1988), and Huang and Stoll (1997). The estimation results show a low importance of the asymmetric information component, which is surprising given that insider trading is considered a serious risk in Ukraine. To present the importance of incorporating the transactions costs into portfolio return analysis, a momentum trading strategy is examined. It is shown that momentum portfolio returns decrease considerably when the cost of trading is taken into account. ii I dedicate this study to God, owing to whose mighty power over the circumstances the work over the study was started and thanks to whose provision of strength and patience it was finished. iii Acknowledgements I am very grateful to my supervisors Professor Seth Armitage and Dr. Janusz Brzeszczynski for their help and support during this project. I particularly wish to thank Professor Seth Armitage for his advice on the important for my study literature, careful reading of the drafts of the chapters and thoughtful comments and suggestions. I am also very grateful for the high standard of research quality and integrity that I could have learned from the example of his work. I wish to thank Dr. Janusz Brzeszczynski for his optimism and encouragement so valuable at the moments of uncertainty and for his help with the econometrics matters. I am very grateful to Yuriy Ryzhkov who carefully matched trades with the preceding bid-ask quotes for his study and granted me the data. This saved me enormous amount of time and effort. I wish to thank David Power who provided valuable help in the earlier stages of the project, to Angelica Gonsalez for her assistance with applying GMM method, and to Andy Snell for his comments and suggestions to my chapter on decomposition of the bid-ask spread. I am grateful to Heriot-Watt University and to Professor Mark Schaffer and Dr. David Brown for providing me with a research scholarship, without which this work would not have been started. I wish to thank following people who gave me valuable information about the practical side of the Ukrainian stock market: Volodymyr Nesterenko, Concord Capital, Kyiv Sergiy Lesyk, Millennium Capital, Kyiv Volodymyr Ovcharenko, Kinto, Kyiv iv Victor Botte, Kinto, Kyiv Oleg Pikarskiy, Kinto, Kyiv Alexander Sandul, Foyil Securities, Kyiv Denys Kolesnichenko, Parex Asset Management, Kyiv Finally, I am very grateful to my family. Their love and encouragement were very important for me during the work at the project. I want to express a special thank you to my Mum for her understanding and care. My thanks to Dad, Vladimir Semenovich, and Sveta. v Contents List of Tables……………………………………………………………………….. xi List of Figures………………………………………………………………………. xv Declaration………………………………………………………………………….. xvi Chapter 1. Introduction…………………………………………………………… 1 Chapter 2. Overview of the Ukrainian Stock Market…………………………. 9 2.1. Introduction…………………………………………………………………….. 9 2.2. History of the Ukrainian Stock Market Development……………………... 11 Formation of the Ukrainian Stock Market………………………………. 11 Development of the Ukrainian stock market during 2000-2010………… 13 The period of 2000-2004…………………………………………………. 15 The period of 2005-2007…………………………………………………. 17 The period of 2008………………………………………………………. 21 The period of 2009-2010…………………………………………………. 23 2.3. Overview of the Ukrainian Stock Market……………………………………. 24 Ukrainian Stock Markets in the Context of European Emerging Stock Markets …………………………………………………………………. 24 Organized Equity Markets of Ukraine and PFTS Stock Exchange…….. 26 Institutions in the Ukrainian Stock Market…………………………….. 31 2.4. Legislation and Enforcement in the Area of Stock Market and Corporate 36 Governance; Information Disclosure and Ownership Concentration in 39 Public Companies …………………………………………………………… Stock Market Legislation in Ukraine …………………………………… 36 Corporate Governance Legislation and Enforcement in Ukraine………. 38 Informational Transparency of Ukrainian Public Companies…………. 45 Ownership Concentration in Ukrainian Public Companies…………… 48 1 vi 2.4. Process of Trading on PFTS………………………………………………….. 50 2.5. Insights of the Ukrainian investment market practitioners on the Ukrainian stock market operation…………………………………………. 56 2.6. Relation of the Specific Features of the Ukrainian Stock Market to the Models Selected and the Results Obtained in the Thesis………............... 64 Summary of the Specific Features of the Ukrainian Stock Market……… 64 Relation of the Specific Features of the Ukrainian Stock Market to the Models Selected and the Results Obtained……………………………… 65 2.7. Conclusion……………………………………………………………………… 68 Chapter 3. Data……………………………………………………………………... 71 3.1. General Description of the Data………………………………………………. 71 3.2. Correction for Outliers ………………………………………………………... 72 3.3. Descriptive Statistics…………………………………………………………… 73 3.4. Details on the Smaller Dataset of 15 Most Liquid Stocks………………….. 77 3.5. Assigning of the Trade Direction…………………………………………….. 79 3.6. Division of Stocks Into Groups Based On Trade Size……………………… 81 3.7. Limitations of the Data………………………………………………………… 85 Chapter 4. The Cost of Trading in the Ukrainian Stock Market……………. 91 4.1. Introduction……………………………………………………………………. 91 4.2. Review of Literature……………………… 93 Quoted Bid-Ask Spread……………………………………………….. 94 Effective Bid-Ask Spread………………………………………………. 96 Price Impact…………………………………………………………… 99 Delay Costs and Opportunity Costs………………………………….. 101 Other Measures of the Cost of Trading ………………………………. 101 Effects of Trade Size…………………………………………………… 102 Difference in the Cost of Trading for Sales and Purchases…………… 107 vii Determinants of the bid-ask spread…………………………………… 109 4.3. Methodology and Data……………………………………………………….. 111 Definition of the rising, falling, and neutral market conditions…….. 114 4.4. Estimation and Discussion of Results……………………………………….. 115 Quoted and effective bid-ask spread…………………………………... 115 Relation of the Cost of Trading to the Trade Size……………………. 118 Difference in the Cost of Trading for Sales and Purchases…………… 122 Determinants of the bid-ask spread…………………………………… 124 4.5. Conclusion……………………………………………………………………… 131 Chapter 5. Liquidity of the Ukrainian Stock Market………………………….. 134 5.1. Introduction…………………………………………………………………….. 134 5.2. Review of Literature…………………………………………………………… 136 5.3. Methodology of the Liquidity Measures Computation …………………… 146 5.4. Data and Methodology of Analysis………………………………………….. 148 5.5. Results…………………………………………………………………………… 152 Preliminary Findings…………………………………………………. 153 Results of the Correlation Analysis…………………………………… 159 Comparison of the Ukrainian Stock Market Liquidity to the Liquidity of Other Emerging Markets…………………………………………… 166 5.6. Conclusion……………………………………………………………………… 171 Chapter 6. Estimation of the Components of the Bid-Ask Spread………… 173 6.1. Introduction…………………………………………………………………… 173 6.2. Review of Literature………………………………………………………….